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Market Review: 18 May 2010

Andrew Dalton, formerly of Mercury Asset Management, now running his own successful fund management firm boutique, provides Independent Investor with regular weekly market reviews. This is his take on last week’s market action in Europe, which has once again called the resilience of the euro project into question, and highlighted the dangers of policymaking errors.

Last week investment attention remained firmly fixed on the problems in Europe. Chancellor Merkel suffered a significant defeat last weekend, which highlighted the lack of support from German voters for a Greek bail out. There were various dissenting voices behind what has hitherto been determined official support for the euro. One German law maker suggested that Trichet should step down because the ECB had bought Greek debt. President Sarkozy threatened at one point to pull out of the euro zone.

Deutsche Bank suggests that Greece might not be able to repay its debts and Paul Volker, in London, suggested that the euro zone might disintegrate. There were riots in Greece and Ireland and strikes are now scheduled in Spain. The unemployment rate in Greece in May will probably be around 13% and over 20% in Spain – and that is before the proposed fiscal drag is applied. Both Spain and Portugal announced cuts in public expenditure.

The €750 billion EU/IMF rescue package a week ago was intended as a once-and-for-all method to solve the EU crisis. It was designed to prevent bond market defaults within the EU and dampen the massive interest rate risk spreads that had opened up for Mediterranean government bonds over recent months. The problem, of course, is that the rescue package, although necessary in the short term, does not address the bigger, long term structural problems.

Over the course of the last week, markets focussed on these longer-term structural problems. The truth is that there has been massive divergence between EU budget deficits, unit labour costs, current account deficits, etc. The EU took only a first small step towards addressing those deeper fundamental problems last week when Spain and Portugal proposed 5% pay cuts for public sector workers.

The establishment of the euro zone in 1999 presupposed that the various countries linked together in monetary union would experience roughly similar fundamental trends. However, that has not been the case. In the last 11 years, fundamentals among EU member nations have diverged significantly, creating the pressures now apparent among the laggard deficit countries of Greece, Portugal and Spain.

The divergence can be seen between Germany at one end of the EU spectrum with its stronger unit labour cost trends, resulting in large current account surpluses, much of which is from rest of the EU. While at the other end of the spectrum, the Mediterranean economies have had weaker unit labour cost trends and much larger budget and current account deficits than Germany.

With 11 years of divergence, Mediterranean governments have backed themselves into unfinanceable deficits and are now forced into belated action. Benefits and wages may have to be cut as much as 30% over the next few years. The bailout out packages can only prevent default in the near term but in the longer run these countries require smaller budget and current account deficits. They need to become more like Germany.

Private capital is now unwilling to fund those on-going Mediterranean budget deficits, and those economies, therefore, are faced with the necessity of bringing wages and benefits down swiftly in nominal terms, since they are unable in practice to raise their productivity sufficiently quickly to close the gap with Germany. Perversely, of course, German industrialists have been the great beneficiaries of the euro. Their southern European competition has become increasingly unable to compete with them, because they have not been able to benefit from regular, if disguised, devaluations against the Deutschemark. Germany has been running an increasingly large trade surplus with the rest of Europe.

Much of Europe now risks having to go through a second recession to right the imbalances. It is difficult to avoid the conclusion that the rest of Europe either has to compete with Germany within the euro or still go through similar austerity measures even if they leave the euro – truly an unattractive choice. Northern European members of the Euro zone, of course, have concomitant obligation to pick up an enormous bill to maintain the euro and, meanwhile, allow the ‘quality’ of the ECB’s balance sheet to deteriorate. In recent months, that fact has caused the euro exchange rate to trade more like a Greek euro than a German one. A European recession would be a major negative for the world economy and trade cycle.

If this were all, the situation indeed would be gloomy. The correct response, of course, is to stimulate growth not foster depression. The ECB will remain under pressure to ease monetary policy both by cutting rates and increasing the size of its balance sheet – quantitative easing. Germany should grow faster. Indeed, it should be noted that the Euro zone economy has been recovering, interest rates in Europe are close to zero and are likely to remain so. The euro has declined almost -20% in the last quarter and global growth is strong.

The world is growing elsewhere. The US continues to grow as is much of the rest of the emerging world. Indian imports in the year to date are up at an annualised rate of 79%. French industrial production is up by 7.8% and ISI’s Truckers survey of commercial traffic in the US has risen a remarkable 39.9% from its recession low. There are steady and incipient signs that US employment is in an up trend. ISI’s Permanent Employment Companies survey increased again last week by 0.8% to 42.9%. This is versus its recession low of 16.1%. And the ISI Temporary Employment Companies survey remained at a strong 61.6%.

We have assumed that the tighter fiscal policy is, the looser monetary policy needs to be. A policy mix of “tight fiscal and loose monetary” is generally positive for asset prices. On a net basis, we have had nothing in Continental European equities for some weeks. For US dollar based accounts, we have wholly hedged any non US dollar positions back into the US dollar. For sterling based and euro based accounts, we have increased our exposure to the US dollar. We have raised our cash levels but we have not yet abandoned the view that a primary trend in equities is intact. However, we have to acknowledge the risk of political disruption and administrative incompetence. Nowhere are these two possibilities more on show than in Europe.

Europe will have to resolve its problems. Ultimately, we expect a fiscal union and possibly a two tier Euro zone. Europe has never addressed the lack of a fiscal union effectively. Without fiscal union, the core EMU countries are effectively giving a credit card to the weaker countries that lack discipline and are too eager for growth at any cost.

Ultimately some countries will have to take a leave from monetary union. Without the option of devaluing their “own” currency, there is no other option than outright default. Therefore, an option that allows devaluation, combined possibly with austerity policies, may be a more realistic option. From the perspective of bond holders, this is just default in disguise. You lend people euros and get back something less.

The likely outcome is that the euro will survive but the fixing process will take time, which will also mean that relative to the US dollar and other regions of the world, Europe will be weak, which is what the market is reflecting.

Written by Jonathan Davis

May 19, 2010 at 5:42 PM

Andrew Dalton’s Market Review

Equity markets rose last week until Friday, when they fell sharply with the announcement of the SEC’s suit against Goldman Sachs.  The picture that emerges from the suit is nasty, plausible but, probably, difficult to prove.  Goldman Sachs was not alone in manufacturing these types of synthetic transactions.  Nonetheless, it appears that the SEC intends to follow the profile of the particular Goldman Sachs transaction known as Abacus 2007 – AC1. 

 Andrew Dalton 2 If the case is eventually proven, the path for compensation for those who lost money would be much easier.  The timing of the SEC’s case is important politically, because regulation of the investment banking community is under active discussion in the US Congress.  It is important, however, to realise that much of what is in contention is already history and the impact on world equity markets, therefore, is likely to be short-lived. 

Of more importance has been the progress of first quarter earnings reports from the United States, which has been good.  As of April 16th, 38 companies in the S&P 500 have reported, representing 12% of total market capitalisation.  The upside surprise ratio stands at 78.9%.  The earnings growth of companies reporting thus far is up 31.8% year-on-year.  The reported earnings growth rate excluding financial sector is 41%.

Elsewhere the Greek situation rumbles on.  The latest IMF/EU delegation expected in Athens today has been delayed by a week because of volcanic ash that prevents flights.  However, it now appears likely that the Greeks will seek to draw down official pledges of assistance from other European Union countries.  This had the effect, at the end of last week, of pushing German government bond yields higher and Greek government bond yields higher still.

In the United Kingdom, the Liberal Democrat leader, Nick Clegg, appeared to do well in the three way debate on UK television between himself and the two other party leaders last Thursday.  The most recent opinion poll even suggests that the Liberal Democratic party has more electoral support than any other party in the UK general election, which is to be held on 6 May.  Even that level of support, though, would be insufficient to give the Liberal Democratic party a majority of seats in the UK House of Commons, although it could double the number of seats they currently hold, making a ‘hung’ parliament more likely.  Sterling weakened.

Part of the difficulty on Friday was that Goldman Sachs did not issue its rebuttal until this morning.  In that rebuttal, Goldman was anxious to ensure that attention should be focussed on this one transaction, which involved two professional institutional investors, IKB and ACA Capital Management.  They pointed out that this particular transaction has been the subject of SEC examination and review for over 18 months and that, based on all that Goldman itself had learned from this examination, the firm’s actions were entirely appropriate. 

Goldman further pointed out that the institutions were very experienced in the CDO market, extensive disclosure was made in respect of each of the securities in the reference portfolio, similar in detail and scale to those disclosures required by the SEC in public transactions and that the offering documents provided all the information needed to understand and evaluate the portfolio.  In essence, the transactions at issue involved a static portfolio of securities, which was marketed solely to sophisticated financial institutions. 

IKB, a large German bank and leading CDO market participant and ACA, the two investors knew about the associated risks.  Goldman pointed out that they were among the most sophisticated mortgage investors in the world, they understood that a synthetic CDO transaction requires a short interest for every corresponding long position.  Goldman Sachs insisted that it never represented to ACA that Paulson was going to be a long investor.  As normal business practice, they asserted, market makers do not disclose the identities of a buyer to a seller and vice versa.  Clearly, Goldman is going to fight it all the way and suits against major broker dealers have been difficult to win.

More generally, the US economy has clearly ended the first quarter on a stronger note than originally anticipated and the second quarter has started even more strongly.  The April manufacturing PMI probably increased to 61.5% and ISI’s company surveys last week were at 46.7 versus 45.4 in March.  Strength in the Empire manufacturing employment index, published on Friday, fits with an improving picture for household employment, which has risen by almost 1.4 million over the past three months.  Credit markets are improving.  ABX prices (ie housing related securities) have surged in the past few weeks from 35.5 to 44.0 and CMBX prices (ie commercial real estate related securities) have risen from roughly 86.0 to 91.5.  Junk bond yields declined last week to 8.05%.

The range of investors’ views is, though, extraordinarily wide. ISI last week tested the views of their clients in a survey and the range of views was wider than at any stage that they can recall.  The expectations for real US GDP growth in 2011 range from 0% to +6%, the range for house prices from -10% to +15% and the level of the S&P index at the year end from 950 to 1450.

One way or another these views will eventually converge.  To our mind, sharply rising corporate profits, strong growth in emerging markets and rapidly recovering world trade argue for higher business spending, still further rises in commodity prices and equity market strength.  It may be that some of this strength has made some investors even more nervous.  Over the last 301 days, the GSCI measure of commodity prices has risen 80.4% – the most ever in an economic recovery. 

Even the most deadbeat areas of economic activity in the United States seem to be catching the mood.  California’s manufacturing PMI for the second quarter increased to 61.7, which is an outstanding figure, and Californian employment data reported last Friday showed that Californian employment over the last three months was actually up 35,000.  New York was up 43,000.

Technically, markets may have been rather overbought in the middle of last week with rises in each of the last seven weeks.  Friday’s action helps to correct that situation but, in our view at least, does not affect the primary uptrend.

Andrew Dalton is the Founder and Chief Investment Officer of the Dalton Strategic Partnership, and previously spent 30 years at Mercury Asset Management in a variety of senior investment positions. His market review will appear weekly in Independent Investor’s newsletter.

Written by Jonathan Davis

April 20, 2010 at 6:22 PM

Andrew Dalton’s Market Review

Andrew Dalton is the Founder and Chief Investment Officer of the Dalton Strategic Partnership. This is his latest global market review, as at March 30th 2010. These reviews will be posted regularly on the Independent Investor website and in the forthcoming new subscription-only publication.

As we come to the end of the first quarter, it is worth reflecting on what has happened in world stock markets. Generally equities are higher, despite a sharp correction between mid January and mid February. Asian markets have been mixed but North American equity markets, by contrast, have shown considerable strength. The great surprise has been the Japanese equity market, which has done well both in absolute terms and in currency adjusted terms. The impact of currency movements has been considerable. Both the pound and the euro have fallen sharply against the US dollar.

In effect, the UK has seen a major devaluation from its 2008 peak and that process of depreciation continued in the first quarter of this year. As a result of this devaluation, UK industry and business has become more internationally competitive. Markets, of course, have worried about the size of the UK government’s deficit and the outcome of the general election likely in May this year. The euro, meanwhile, has been overshadowed by the problems of Greece and the fear that these problems are both more fundamental and likely to have a more widespread impact elsewhere in Europe too. So far these problems have been contained and Europe, as a whole, has benefitted from a modest rerating of the euro. It is an open question as to how much further this has to run.

Throughout the period, we have remained as fully invested as possible in equities, taking the view that equity markets remain in a primary bull trend. We have taken this view since early May 2009, and had been building up towards that position over the six months prior to that.

Over the quarter, there have been some significant shifts in our asset allocation between equity markets. For a fully invested equity portfolio, we have ratcheted up our exposure to North American equities further – such that at the end of March, our total exposure in this area is around 46% of net assets compared with a 34% exposure at the end of last year. Our Japanese exposure has also risen to around 7% of net assets, for a fully invested portfolio, compared with 2% at the end of December.

This has been possible as a result of a relatively low exposure to Continental European equities (around 5% at the end of March) and by squeezing our exposure modestly in Asia ex-Japan. The latter accounted for 14% of net assets at the end of March, compared with 17% at the end of December. We have avoided bonds, partly because our risk budgets have been fully absorbed holding equities and partly because we remain concerned about the deterioration in government finances in various parts of the world. Our sense is that government bonds are in a low grade bear market. Thus far the selling pressure has mainly been felt in the peripheral euro area bond markets.

The UK budget last week provided a snapshot of the UK’s fiscal position. The UK Chancellor’s budget judgement was relatively conservative. The UK Chancellor revised lower his forecast for the UK fiscal deficit from this fiscal year and the subsequent five years by an average of £9.2 billion a year with the biggest downward revisions in the first two years. In essence, the UK government locked in the gains from the recent better-than-expected deficit prints.

Where previously the UK government had been looking to halve the deficit in four years, it now expects to more than halve the deficit over that period. As a result, the UK government expects to restrict the debt incurred by the end of 2014-15 by a further £75 billion or to 75% of GDP. This decision to save the benefits from improved economic performance contrasts with the Pre-Budget Report where the Chancellor ‘spent’ most of the benefit from positive revisions.

The UK government generally stuck to its GDP growth forecasts. Growth is still expected to be in the region of 1.0%-1.5% for this year which, as it happens, is broadly in line with market expectations but, for next year, the Chancellor nudged his forecast lower by 25bp to 3.0%-3.5%. On the revenue side, the Budget forecasts show a robust 6%-7% recovery in receipts each year from April this year. The main news on the revenue side was the decision to phase in fuel duty in three stages from April to January instead of a bullet 3p increase in April.

No doubt this gradualist approach reflected the imminent general election. There were no changes in VAT, income tax or capital gains tax rates. However, the higher income tax rates and national insurance rates announced in the Pre-Budget Report in December will go ahead as planned.

The UK government’s spending plans were kept deliberately value. However, there will be sharp spending cuts after the general election and there are indications that government departments are well advanced in preparing options for the incoming administration. Meanwhile, so called ‘efficiency savings’ have been stretched to the limit of credibility.

Within our North American equity portion, we have had substantial exposure to Canadian equities which, of course, have a bias towards natural resources. This has been helpful. Canada is a major beneficiary of strong resource prices. Rising commodity prices have helped its currency to rise steadily in recent years. Somewhat more effective regulation has helped Canadian banks to avoid the massive losses that caused havoc in the US and European financial sectors. The fiscal picture also is the best among the major developed countries and the Canadian economy’s performance compares favourably to that of most other developed countries.

The likely strength of the cyclical recovery in the US has been central to our view of the world for the last nine months and that view appears to be working out. The US now has a competitive currency, competitive labour costs, robust corporate balance sheets and economic data confirms that the country is on a solid recovery path. This has been and is likely to continue to be positive for equities. The prospect for US dollar bonds is less obvious. As US economic and financial conditions continue to normalise, real yields should also normalise. Indeed, yields on US Treasuries have been rising – recently US Treasury bond auctions have been received tepidly and 10-year swap spreads have turned negative. In this sense, markets are making a return to the mean move.

In the event, the EU heads of government provided some sort of back up undertaking to Greece last week. There was no commitment to concessionary terms and a role was provided for the IMF which, frankly, is the only institution with the experience, people and processes in place to implement a package and then to enforce the fiscal discipline that will be necessary within a relatively concentrated three year timetable to close the Greek government’s fiscal deficit. This will be painful, as the latest Irish GDP numbers issued last week demonstrate.

We now know that Irish GDP fell by 2.3% quarter-on-quarter in the fourth quarter of 2009. This was far weaker than t he 1.0% quarter-on-quarter contraction expected. At the same time, the third quarter reading was also revised down to -0.1% quarter-on-quarter from a previously reported increase of 0.3% quarter-on-quarter. The contraction in the Irish economy has been led by declining investment (-9.7% quarter-on-quarter, after -10.3% quarter-on-quarter in the third quarter) – indeed, Irish investment has now fallen by a staggering 52% since the peak in the first quarter of 2007.

On the output side, that is reflected by ongoing weakness in industrial gross value added. Elsewhere on the expenditure side, private consumption in the fourth quarter fell by 0.3% quarter-on-quarter and government spending was down by 0.8% quarter-on-quarter. Net trade had little impact in the fourth quarter, with exports edging up by 0.1% quarter-on-quarter and imports falling by the same magnitude. As a result, the Irish economy has now contracted by 12.6% since its peak in the first quarter 2007 (and 18.7% in normal terms). Not surprisingly, asset values have taken the biggest hit. Household wealth has declined sharply.

All of this reinforces our view that European growth faces real headwinds in the months ahead as some deflationary forces are unleashed.

Written by Jonathan Davis

March 31, 2010 at 5:30 PM

Andrew Dalton On The Markets

As someone who is required to read a huge amount of written material about investment, I have spent many years looking for experienced professionals who can write both clearly and with integrity about the the changing dynamics of the markets. By that I mean experts who are not just easy to read and understand, but who have the judgment and experience to be able to distinguish between “noise” and substance – to pick out what matters from the daily torrent of information and data that is now available to all market participants courtesy of Reuters, Bloomberg, the Internet and traditional news media.

One of the few who meets this demanding set of criteria is Andrew Dalton, who spent 30 years as one of the key senior management team at Mercury Asset Management before setting up his own fund management firm, the Dalton Strategic Partnership, seven years ago. He is going to be contributing his weekly market reports on a regular basis in future for Independent Investor. This is his take on the events of the week ending 7 March 2010.

The rally which began in mid February has continued last week. The pressure associated with Greece lifted slightly. The Greek government completed a €5 billion bond issue, albeit at 35bp of yield above the market. This provided modest relief to the Euro on Friday. From a technical point of view, equity markets maybe slightly over-bought on a short-term basis. However, there has been a notable decline in selling pressure over the last three weeks, together with signs of greater buying power.

Markets have broadened, particularly in the United States, where it is now clear that mid cap and small cap indices are above their early January highs, even if the S&P itself is not yet there. Economic statistics, coming out of the US have been complicated by severely bad weather conditions in February. Nonetheless, the US Federal Reserve Beige Book gives some comfort that economic conditions continue to improve albeit at a relatively gentle pace.

The US non manufacturing ISM index rose to 53 in February, which was above consensus expectations. The details included solid gains in the employment and new orders components. The ISM indices typically are not particularly susceptible to storm related distortions, which are likely to have a bigger impact on payroll and consumer spending data.

Reports from the 12 US Federal Reserve districts contained in the Beige Book indicated that while economic activity remains at a relatively low level, conditions have improved modestly since the last review and those improvements are broadly spread geographically than in the last report. Ten districts reported some increased activity or improvement in conditions, while the remaining two reported mixed conditions. In the last Beige Book eight districts had reported increased activity or improving conditions. Most districts reported that consumer spending in the recent 2009 holiday season was slightly greater than in 2008 but still well below 2007 levels.

Retail inventory levels remain lean in nearly all districts. Auto sales held steady or increased slightly since the last Beige Book in most districts. Non financial services activity generally improved in districts that reported on this sector. Manufacturing activity has increased or held steady since the last report. Among districts reporting on near term expectations, the manufacturing outlook was optimistic but spending plans remain cautious.

This is all good news from the equity investor’s point of view – a positive story but not overblown. There is still enough weakness to reassure the banks that interest rates are not likely to go up soon. Towards the end of 2009, home sales increased in most districts, especially for lower-priced homes. Home prices, this time, appear to have changed little since the last Beige Book and residential construction remains at low levels in most districts. Commercial real estate was still weak in nearly all districts with rising vacancy rates and falling rents.

In essence this reaffirms that while there are clearly some divergences of opinion between FOMC members, the Fed will not feel any pressure to tighten policy or withdraw liquidity (beyond what is already scheduled). Elsewhere, notwithstanding the strength of the Japanese yen, Japanese exports are recovering quite sharply. Japanese exports have risen 46.8% from a year ago while imports are up 34.7%. The trade surplus in February was ¥99.4 billion, up from a deficit of ¥141.5 billion a year earlier. On a seasonally adjusted basis, exports have accelerated steadily from 0.6% growth (a month) in July last year to a record 8.6% month-on-month rise in January. Meanwhile, the Japanese stock market is cheap still.

The problem is to identify who will be the buyers. In Japan, foreign investors were net buyers of Japanese stocks for the third week in a row last week by a ¥82.5 billion margin (down from ¥100.5 billion the week before). Japanese trust banks, though, were net sellers of ¥86.6 billion shares. Individuals were net buyers but only by a ¥1.0 billion margin, although this compared to being net sellers of ¥49.0 billion the previous week. The press commenting on the Japanese Ministry of Finance’s latest corporate statistics report are still pessimistic and focused on the weakness of current corporate fixed investment spending instead of the 102% rise in profits. In fact, Investment spending has fallen 17.3% from a year earlier.

Our guess is that it will pick up. Anyway, Japanese corporate profits bottomed in 2009 January to March quarter, albeit at a historically low level. Looking at the four previous corporate earnings upcycles excluding the current one), on a simple average basis they have lasted 13 quarters, which suggests that the recovery will continue quite some more time. Capital expenditure has continued to fall but, historically, capital expenditure bottoms out approximately six months after capacity utilisation bottoms out, which has already happened. We remain modestly positive about Japan.

Written by Jonathan Davis

March 9, 2010 at 10:00 AM