Why you should ignore the UK stock market bears

published 28 June 2006

The global sell-off in stockmarkets is being blamed on "a cocktail of worries over the outlook for inflation, interest rates and economic growth", said Chris Flood in the FT last week. When you read phrases like "a cocktail of worries", two things spring to mind. Firstly, you're probably not going to understand the explanation that follows. Secondly, neither will the author. Although things look confusing at the moment, there are logical explanations for what's going on and we should be able to lay our investment bets accordingly. We need to look at where we are currently in the economic cycle, forecast what the next stage is likely to be, and decide exactly what that means for markets.

Investing in UK shares: is inflation a threat?

Let's look at the economy first. There's a time during every great party when things are going well. The alcohol has relaxed inhibitions and the music is acting like a siren call to the dance floor. But everyone knows the fun can't last forever. Sometime between now and tomorrow's hangover, someone will fall over, someone will be sick and possibly a fight will break out.

Economic cycles are like that. Central banks often get a new party started by spiking the punch with the vodka of low interest rates. This makes it cheaper to borrow; the borrowed money gets spent, the economy grows and asset prices rise. The party-goers feel wealthy and all seems right with the world.

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But after a while, the central bankers worry that too much of a good thing will lead to inflation. A little bit of inflation does no one any harm; it greases the wheels of the economy and helps promote growth; this is why most central banks target inflation of between zero and 2%. However, if people expect higher inflation, they demand higher wages. Many firms don't believe they can afford these and refuse to settle. Suddenly it seems everyone is on strike and the economy seizes up. It is this wage-cost-push inflation' that caused so much damage to Western economies back in the 1970s and 1980s. Today's central bankers will do anything to forestall that happening again.

One factor being blamed for the sell-offs was the release of the US consumer price inflation (CPI) figure for April, which coincided with the start of the decline. This came in at 3.5%, which many people feared was an early warning of more inflation ahead. However, US CPI had been higher than 3.5% several times during the preceding months. So were markets slow on the uptake? Or was it something other than inflation that triggered the flood out of stocks?

Investing in UK shares: have investors rushed to bonds?

What if the sell-off was caused by markets suddenly paying attention to higher rates? After all, US short-term interest rates have been rising steadily for more than two years. Now, at 5%, they're forecast to rise to 5.25% or even 5.5% soon, because CPI is above target and still rising. In the 1987 crash, after interest rates and bond yields had risen steadily, a tipping point was reached and money flooded out of stocks.

But back in 1987, once those bond yields triggered a rush out of equities, we saw that huge flood of money move not just out of stocks but into bonds at the same time, causing yields to drop sharply (bond yields fall as bond prices rises). But that other shoe has simply not dropped this time. Since 9 May, when the trouble started, US 10-year Treasury yields are essentially unchanged, while UK gilts and German bond yields have dropped just 2%. This is a far cry from 1987, when German and US 10-year government bond yields one month after the October crash were nearly 14% lower. Clearly funds haven't been tempted out of stocks and into bonds on anything like the scale of past events. And as the chart on page 24 shows, rates have now jumped to the level where you might expect them to start heading south again soon. In fact, many people feel that ex-Federal Reserve chairman Alan Greenspan's legacy to his successor, Ben Bernanke, was to "re-load the gun" by getting short-term rates back up to levels where any economic or market crisis can be immediately addressed by rate cuts. So bond yields are unlikely to get much more attractive.

Perhaps rising rates have sucked money out of stocks some other way? Japan's central bank, the Bank of Japan (BoJ), has recently been running down its current account balances as it prepares to abandon the zero interest rate policy it has used to battle against deflation. This has led to heavy selling of Japanese government bonds (JGBs), which pushed their yields up. This may have upset the carry trade', where speculators and hedge funds borrow money where it's cheap (Japan) and lend or invest it where the yield is higher. One sign the carry trade may have been unwound is that the yen rose sharply between mid-April and mid-May, from 118.6 yen to the dollar to 109.8. Currencies just don't suddenly gain 8% in a month against the dollar for no reason.

But hedge funds using the carry trade are using borrowed money. If they stop using those borrowed funds, they pay them back; they don't transfer those funds over to the bond market. So this would also explain the lack of action in global bond markets, excluding Japan. The good news is that if the carry trade unwind was the primary cause of the stockmarket sell-offs, then it was a one-off and everything should be returning to normal. But what if the markets' slide was triggered not by inflation or interest rates going up but by the economic outlook getting worse?

Investing in UK shares: is global growth slowing?

At first blush, this looks absurd. The OECD has revised global growth up; first quarter US real GDP growth was revised up from 4.8% to 5.3% annualised. However, the motor driving the world's economic growth for the last decade or more has been the US. For years, US consumers have been raiding their piggy banks so they can keep spending. Mostly they've done this by using higher asset prices stocks during the dotcom bubble and more recently their houses to borrow against. But the days of crazy dotcom stock valuations are long gone and house prices are turning south, too. Last year, Americans had a negative savings rate for the first time since the Great Depression. Households are spending beyond their post-tax income by the equivalent of 6% of GDP. Something has to give.

This is why some people believe the outlook for 2007 is very different to 2005-6. What we have seen so far is strong economic momentum and inflationary pressures; the fear now is that we could be on the cusp of a sharply lower US consumption and hence slower GDP growth.

US GDP is measured quarter-on-quarter sequentially and then annualised. This is why the first-quarter number was so strong at 5.3% it followed the artificially depressed fourth quarter, with the fall-out from Hurricane Katrina. Any small rebound to normal in the first quarter was artificially exaggerated by the annualising effect. The second quarter is going to be far more mundane, with early indications suggesting less than 1% growth. Add in a weaker housing market and the consensus economic growth outlook could do a complete about-face.

The higher interest rates and tighter money we're seeing around the world are likely to mean a significant dip in growth for the G7 nations. No wonder Bernanke has been indicating that inflation is not something to be too concerned about. In fact, many economists are looking in a completely different direction. US short-term interest rates are close to exceeding the yield on 10-year Treasuries a situation known as an inverted yield curve. The US has never had an inverted yield curve without a recession.

Investing in Uk shares: what will happen to stock prices?

What does this mean for markets? We know commodity prices came off much harder than blue chip stocks. So it doesn't seem logical that inflation is what spooked markets. If you're scared of inflation, you might sell stocks, but you'd buy commodities and sell bonds. Yet commodities fell hard and bonds gently rose. It doesn't fit. Next, we supposed that higher bond yields sparked a fund flow out of higher risk assets and into the relative safety of bonds. Yet we see no such flow into bonds except in Japan, where bonds had previously been heavily sold off as a result of the BoJ reducing its current account balances. Besides, some high-risk assets, most notably emerging market bonds, weren't sold at all. So we deduce that no 1987-style crash is upon us. There is evidence the carry trade was disrupted by the BoJ selling off bonds. But if this is so, the BoJ's new target balance has been reached and the operation is complete. Both Japanese bond yields and the yen should slide again and markets should bounce back to where they started from.

So our conclusion is that US growth and hence the world's growth could be about to slow sharply, as global easy money comes to an end and US households are forced to cut spending. This looks bad and has rattled markets. But an economic downturn is not the same thing as a market downturn. This is because a weak economy has two effects on stock prices, one negative and one positive; and the positive one almost always outweighs the negative one.

A weaker economy lowers revenue growth and can hurt profit margins. But it also leads to lower bond yields. The lower bond yields go, the less stocks have to yield to be attractive compared with bonds and so stock valuations rise. Warren Buffett has pointed out that over the last hundred years in America, almost all stock market gains have been made during periods when the economy grew slowly, not when it grew fast.

But first there will be the small matter of how markets deal with the combination of higher inflation and slower growth the dreaded stagflation. This could mean volatility, so solid, cheap, high-yield stocks that aren't too sensitive to the economic cycle, are probably the best defence. But steer clear of emerging markets, especially the US-reliant BRICs (Brazil, Russia, India and China). Just because their bond markets have stayed up so far, it doesn't mean they'll be able to stay healthy when the US gets its cold. Instead, look at the FTSE 100. It has apparently already stopped falling and has broken its downtrend (see bottom chart, left). It would be incautious to say that there won't be further volatility, or that we've hit the bottom already. But far too few people give credence to the notion that we could bounce back up nearly as fast as we came down.

This, to my mind, is the sort of buying opportunity that investors should seize. How many times have you looked back and wondered why no-one told you to buy at the time of this dip or that sell-off? People were generally bullish a month ago at 6,100. I believe we're still in a bull market and I'm willing to bet that we'll be back at 6,100 and bullish again before the year is out. The trick is to be bullish now.

Good bets for unsettled times

Back in November, I wrote a bullish market piece recommending several stocks and themes. I thought machinery makers should continue to do well on the back of decades of under-investment and the commodity story and, despite the recent sell-off, they have: Deere & Co is up 28% since then, Caterpillar up 23%, Bucyrus up 37% and Komatsu up 24.5%. I also tipped the retailers Tesco (up 8%) and Marks & Spencer (up 30%) and the major pharmaceutical stocks GlaxoSmithKline (down 3%) and AstraZeneca (up 16%). By comparison, the FTSE 100 has gained 3% since then.

Going forward, how would I feel about these names now?

The commodity capital-investment plays are unlikely to continue performing once the realisation dawns that US growth must slow, so I would sell them now into any post sell-off trading rallies. However, I'm still keen on the retailers and the pharmaceuticals, all four of which are on about 15 times this year's forecast earnings, with dividend yields ranging from 2.4% to 3.1% in the case of Glaxo.

It wasn't all good news, though. I also liked the look of the oil majors Royal Dutch Shell and BP, both of which are disappointingly down 7% since then, as well as the reinsurers Swiss Re (down 10%) and Munich Re (down 4%). The story in both these sectors remains largely unchanged or even rather improved, so with prices even lower these sectors look even more attractive in my book.

Shell, for example, looks particularly attractive as it is on a forecast p/e of just 9 times, though bizarrely this is predicated on the consensus belief that earnings per share will fall this year from $3.78 to $3.62. This looks unlikely to me: last year was badly affected by Hurricane Katrina, the oil price averaged $56.60 last fiscal year and is more than 22% higher at $69.30 today and company profits in the first quarter of the new year rose again from the year before for the eighth consecutive quarter in a row.

The reinsurance names I liked because the huge Hurricane Katrina pay-outs were likely to give these companies virtual carte blanche to raise rates. Sure enough, they have both seen consensus forecast earnings for next year steadily revised up by about 10%. Recent analyst earnings per share targets put Swiss Re on about 7.85 times to December 2007 almost a record low. Munich Re is hardly more expensive on 8.2 times.

Added to that, two other sectors which have only made single-digit gains since I recommended them to MoneyWeek readers are insurance and banks. Here again, earnings have been steadily revised up; Legal & General and Aviva on the one hand and Barclays and Royal Bank of Scotland on the other are all on single-digit p/es, with dividend yields of between 3.7% and 4.4%. Christmas has come early this year.