There has certainly been plenty to worry about recently particularly if you are one of those peopl...
There has certainly been plenty to worry about recently particularly if you are one of those people like me who tends to round off their evening by watching the BBC 10 o'clock news. The likes of Marconi, Railtrack, Enron, and Vodafone have all provided plenty of reasons to stay awake at night and if we were to categorise them they would give four reasons for insomnia.
• Corporate failures ' how many more casualties can we expect?
• Accounting irregularities ' feeding off the Enron saga. Can we trust the numbers?
• The pensions time bomb - how big is the liability? And finally,
• Investment banks ' is there a conspiracy to mislead.
Moving to the first of those ' Corporate failures and how many more casualties? We have to say this is the standard, all be it a very unfortunate feature, of a normal investment cycle. Economic set back does expose balance sheet weakness.
If the business is coming through at a slower pace then obviously some companies will get into some difficulty. It is important to realise and accept that more companies go bust in the first year of recovery than in the last year of recession. We certainly feel we are in that first year of recovery as regards to the macro stance.
At this stage in the cycle there is a very important balance to be drawn between the economic and macro risk, and specific risk. As we are seeing the recovery the macro risk is reducing, but of course we still have the specific risk that one or two companies will suffer at this stage.
Do you remember the three FTSE 100 stocks that went bust at this stage in the last cycle after the last recession? People tend to forget that we had three of them back in those days.
Moving on to the second point ' accounting irregularities and can we trust the numbers?
It is a case much appreciated by our analysts that financial statements have never been more complex, and they are getting more and more difficult. But accounting is not objective, it will never be so and can never be so.
All general accounting principles will have loopholes and weaknesses and there will be room for manoeuvre. In most cases a good accountant will look for loopholes and allow companies to gain advantage from it.
The economic slowdown will mean diminished access to fresh capital. This will reduce companies' margins forever and, it is interesting to note, during 2000 some 333 companies in the US had to restate their numbers. This is about double 1997's level. We would expect the numbers for last year to be equally high and we would also expect 2002 to be pretty high as well.
All these current problems should improve the quality of accounts going forward, but that is not happening perhaps yet and again it is part of the cycle that accounts will improve in the early stages of the recovery of the cycle. The accountants will spend their time then looking for the loopholes, looking for room to manoeuvre and by the time we get to the next downturn, the next recession all these sort of faults will be highlighted once again.
The third point ' the pensions time bomb. This is again something we have all been very concerned about recently particularly with the talk we have had from Boots, for instance, which switched the pension scheme's assets from equities into gilts.
The reason for this concern I think is, primarily in this country, the move from SSAP24 to FRS17. FRS 17 is as fantastic cure for insomnia. Our head of research has managed to distil it down from 51 pages into four points. This is the way in which FRS17 differs from SSAP24. FRS17 is the difference between assets and liabilities and must appear on the balance sheet. Service costs will be charged to the profit and loss account. There will be a reduced ability to smooth the cost, and finally and most importantly the way in which this all comes together. There will be increased visibility and sadly increase volatility as well.
In terms of the impact, well the vast majority of company pension schemes currently are reasonably funded. Remember that this is simply an accounting change, the state of the pension schemes has not changed as a result of this. So the need therefore for investment professionals is to remain very vigilant, to look at and analyse the companies, and look at the specific cases where this may be perhaps a problem. It will encourage companies to adopt a more conservative approach which I think we have seen already.
They will close schemes perhaps to new entrants entirely, they will review their benefits and there will accept a higher contribution. We don't believe, however, that this is a generic, major problem for the market. Not unless the economy takes a major turn for the worse and the stock market follows it.
Finally then, investment banks and is there a conspiracy to mislead? Well the issue is that _yes' there is certainly a conflict of interest there. Investments banks advise companies; their broking analysts make recommendations.
A lot of people lost an awful lot of money in the technology bubble. So there are an awful lot of unhappy people out there, particularly in the US.
Our observation again is that this is nothing new. This has always been the case and if anything it further supports the growth in in-house research teams, which further supports the need to grow that in-house research team to give independent unbiased views of the companies. We will monitor the track record of the issuing houses. Importantly some of the houses have worse records than others and I guess this is partly tied into the fact that some of the houses over the last few years have greater inflows of tech-related business. That point is not forgotten by the market. Their reputation is at risk and they do have a duty of due diligence in this regard. We keep a very close eye on it.
We have seen just recently that the SEC will require changes in investment banks. We have seen this personal crusade by the New York Attorney General, Elliot Spencer in this very high profile campaign against the investment banks.
So in summary on those four issues:
Corporate failures ' how many more casualties? Unfortunate, but not unusual state of affairs at this stage in the cycle. More companies go bust in the first year of recovery than in the last year of recession.
Accounting ' can we trust the numbers? Well, no. We must keep taking a very sceptical approach. Accounts will always be misleading. They will always have that potential.
Pensions ' How big is the liability? Well, as I said, likely not to be a generic problem unless the economy contracts sharply, but we will have to be vigilant looking at the stock specifics.
And finally, is there a conspiracy to mislead? Well there was certainly a bubble when investors forgot to question judgements and there will have to be further emphasis, we believe, on the importance of in-house, unbiased, unprejudiced research.
In overall terms therefore, unwelcome but not uncommon features of a normal investment cycle. And we do not mean to dismiss these issues, or suggest they are unimportant or not worrying.
What we are simply doing here, hopefully, is to suggest that we need to keep these issues in context. The context we believe is that the market is sitting too close to the television. It is so worried about the change in pixels it is missing the bigger picture. The issues I have just described we would regard as the changing pixels ' the bigger picture. To quote from the Clinton Presidential election campaign in the second term we would say: 'It is the economy stupid.'
What you have seen more recently is that the UK market, in our view, is yet to fully discount the improving global economic picture and that the micro picture is clouding the bigger macro picture.
You have seen in the past a very strong correlation between the year on year change in the global leading indicator and industrial production, normally with a sort of six month lag behind. So that in six months time, six months from when the global leading indicators began to turn over, you would expect global industrial production to begin to pick up. The global indicator was turning over, particularly at the start of the year, so mid year we would expect the global picture to start to get better.
The fact that we are still getting very worrying statements, very worrying numbers out of reporting companies in the US and the UK, shouldn't be that much of a surprise at this stage in the cycle. Obviously this is the balance to be drawn the macro and micro issues.
What has taken us all by surprise this year? Well, I have to say once again it has been forecast for GDP growth. Back in November the consensus figure for US GDP for 2002 was about 0.7% growth.
I have to mention our own in-house economist, Steven Andrews, who at that time forecast 1.8% ' well out on a limb. He stuck with it because he truly believed that was where the number was heading and, sure enough, the consensus has been moving very, very rapidly up to and past that number.
We have moved up slightly, but the consensus moved up very, very sharply. And the surprise about this is that it is nothing new. The consensus for the US GDP over the past few years has consistently been wrong. I read recently that HSBC Bank said that no single paid economist got the consensus figure right in 1999 and 2000. They were all far too bearish, too cautious. They were all far too high in 2001, so whatever the consensus is saying at the moment you can be sure that it is wrong.
We started 2002 far too low and it moved up very rapidly. The reason it has moved up so rapidly is, in the majority, quite simple; it is inventory re-build. It was simply the case that towards the end of last year inventories in the United States were just too low, the pipeline was bare, the shelves were empty.
What you saw in the final quarter of 2001 was a sharp movement upwards in inventory levels. I guess the danger, particularly that Andrew is pointing out now, is that people extrapolate forward that very strong number and come up with very strong numbers for the year as a whole.
In the pursuit of balance I now propose to give three reasons why we should still be very happy about the general economic outlook and why we should be a little more circumspect perhaps.
The first reason to be cheerful is that new orders are healthily outpacing inventory correction (see graph top left).
Secondly and you may feel this is a little tenuous, but you see this small improvement in capacity utilisation ' very small perhaps but it is beginning. Particularly in the old economy ' the old economy still has major problems (middle graph).
The final reason to be cheerful is the valuation of the UK market (graph bottom left).
Real earnings growth in the market is implying a low number of about one and three quarter percent as opposed to the two and a quarter percent we have averaged over the last 10 years. There is an interesting piece of research currently which looks at the FTSE 100 excluding Vodafone ' so the FTSE 99 ' claiming that Vodafone has a big distortionary impact on the FTSE.
If you took Vodafone out then the FTSE P/E would come down a full 5 points from 22-23 times to 17-18 times.
What we are saying about the UK market is that it looks good value at present ' it is not excessively cheap but it is good value we believe.
The three reasons to be slightly more circumspect perhaps and more questioning:' Is this as good as it gets?' Every closely followed index in the US is suggesting that it is at or near peak levels. So is this as good as it gets and is it the only way down?
Secondly, looking at the US yield curve. The steeping of the US yield curve has been quickest for almost 20 years and the UK is also at a five year high. The central banks lead the cycle which is why we were becoming a lot more optimistic about the markets last year. But it is also a reason for being more cautious now.
Monetary easing has come to an end and rate rises will occur at some stage during the year. In the light of the news from the Nationwide about the housing market I believe that rates cuts are further out than mid year.
So what have we been doing with our investment strategy over the past eight months. In August last year we started moving into clean cyclical areas, the bigger blue chip names, bigger household names. Unfortunately the events of 11 September didn't do that strategy any good at all but we stuck with it and performance came through thick and fast on the back of that come turn in the markets.
What we are suggesting now is that this cycle is moving on and the next stage must be to look again at the traditional growth type areas. On technology we are neutral. Don't forget that this sector is not a big area of the FTSE ' about 1.5%, if that. So please let's not get too hung up on the technology sector.
To bring this to a close we have commented on the number of issues worrying the markets at the moment. The consequent effect is the UK markets have been stuck in this horrible trading range for about 6 months now, and while we don't wish to dismiss these issues we would simply say that they are not uncommon at this stage in the cycle. We have been here before. But the big picture is improving and the market offers reasonably good value at current level. Good value rather than exceptional value.
So finally, in continuing with the television theme, we thought we would end with the words of BBC commentator Nick Ross.
_Don't have nightmares please, sleep well.'
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