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Fighting Fear - Justin Urquhart-Stewart Commentary

June 01, 2010

Fighting Fear

Whether fact, rumour, hearsay or tittle tattle, whether from an ill-informed or respected source, when fear grips a situation sometimes even the strength and sheer logic of facts will get washed away in the flood of a frenzy.

Certainly there were times last week when the equity markets around the globe were being smacked around with all the erratic behaviour of a pinball machine. Of course we shouldn’t really be surprised as we are constantly bombarded with news, views and numbers from all directions which as a result, but for the double glazing, would have had many heading for the windowsills.

The equity market correction over the past few weeks has been both vicious and painful. I think it is fair to say that it has primarily been the concerns over European sovereign debt have driven this volatility and at the moment it is far from clear that this nervousness is over: however, the huge Eurozone financial dyke and support package announced a week ago is a major step in the right direction, in terms of buying time for governments to address their deficits (which many are now doing, more aggressively). For once it is showing tangible evidence that the authorities appreciate the seriousness of the situation. There is of course more work to do on that front in Europe and especially with the redesigning of the control and disciplines around the Euro.

Elsewhere – the UK’s £6bn planned budget savings are just a drop in the ocean, but the long journey back towards fiscal responsibility has at least begun and now we have to wait for the Budget later in the month to see if a credible plan can be laid out. This will particularly have to address the issue of social welfare expenditure and benefits.

The sabre-rattling across the Korean border has come at a bad time too. That situation needs monitoring but a major escalation currently looks unlikely but with Mr Kim logic and common sense are in short supply and in an unstable situation with the potential for domestic collapse, frankly anything could occur.

Thus markets are likely to remain volatile, and there is a risk of another leg lower at some stage, but at current levels equities offer value on some measures. Time to look through the fear to some financial facts. Dividend yields on major indices in Europe are higher than government bond yields: this was the norm until the 1950s but has only been seen twice since until the current episode – in March 2003 and March 2009: both occasions marked major turning points. Corporate earnings are making good progress, and equities offer reasonable value on a PE basis, with major European markets trading around 9-10x earnings (the FTSE at 5000 trades on 10.2x 2010 estimated consensus earnings, 8.4x 2011 estimated). The global recovery is still progressing – with flickers of concern, for sure, such as house prices in the US, but on balance still pointing towards growth in the world economy for now – though doubts remain about 2011.

The picture is still mixed and the risk of another episode in the Eurozone government borrowing saga should prevent us getting too carried away. However, at current levels the value on offer in equities is enough for us to justify an initial increase in risk in the 7IM portfolios and we have bought a small initial position in LSE-listed FTSE call warrants (currently 5% out of the money, with around 6 month expiry).

Facing fear with a contrarian view is always controversial but for a small proportion of the portfolio is interesting potential for our money.

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Interest rates and Inflation. The fear of inflation for the UK led the OECD to warn The Bank of England that interest rates may have to rise to 3.5% by the end of next year, and that this rise in rates should start no later than the last quarter of this year. This of course is in stark contrast to the comments made by The Bank that inflation will start to fall in the middle of the year and then drop well below target and even remain there for several years to come. So who is right?

Any significant rise in rates could certainly weigh heavily on the fragile UK recovery and the authorities would probably prefer to keep them as low as possible for as long as possible even at the risk of further inflation. Remember politicians quite like a bit of inflation because of its mercurial ability to dissolve debt over years (whilst also devaluing the economy), but of course with an ‘independent’ Monetary Policy Committee such decisions are not directly under their control – but do not underestimate their power of influence.

So who do we believe? The OECD has by no means an impeccable track record of forecasting (nor has anyone else for that matter) but certainly the concern that the UK is building up inflationary pressures for 2011 and beyond has been a growing consensus in the City.

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Next week will see the release of rather comically named ‘non-farm payrolls’ in United States. These will tell us how many new jobs were created in the US economy in May with the consensus of analysts hoping to see a robust increase of 500,000 and a drop in the unemployment rate to 9.8%. There is relatively little economic news out of the UK, although we will get some statistics on the housing market, which unfortunately seems to have been slowing down a little of late – good news for first time buyers perhaps, but not for those looking for signs of a strengthening economy. Finally, there is a meeting of G20 finance ministers and central bankers in South Korea next week. Let’s hope Mervyn King and George Osborne don’t have to put on their tin hats!

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And finally............another glorious headline to be savoured.... ‘Man sucked into sausage seasoning machine.’

Danvers, Massachusetts. Police said a cleaner was taken to a hospital after being sucked into a machine at a sausage-making company. The accident happened as the man was cleaning the vacuum-type machine that is used to season the meat at DiLigui Sausage Co. Police said the man's head and shoulders became stuck in the machine after it somehow activated while being cleaned.

So probably we were right to have been suspicious over the contents of certain sausages and with a name like DiLigui there are immediate connections with The Sopranos.

Have a good week.

Justin A. Urquhart Stewart
Director
Seven Investment Management Limited

Towergate Financial is not responsible for the content of this article. The opinions expressed therein are those of the author.