PF7E - page 1
Division(s): N/AITEM PF7E
PENSION FUND COMMITTEE – 26 AUGUST 2005
OVERVIEW AND OUTLOOK FOR THE INVESTMENT MARKETS
Report by the Independent Financial Adviser
1.The economic cycle is maturing. Leading economic indicators have been falling for a year (see chart below) and industrial production appears to have peaked in the developed countries.
Figures for gross domestic product (GDP) since the trough in 2002 show the trend by regions.
% growth
2002 / 2003 / 2004 / Consensus2005 / Forecasts
2006
UK / 1.8 / 2.2 / 3.2 / 2.1 / 2.3
USA / 1.9 / 3.0 / 4.4 / 3.6 / 3.2
Eurozone / 0.9 / 0.5 / 1.8 / 1.3 / 1.7
Japan / -0.3 / 1.4 / 2.9 / 1.5 / 1.5
2.The forecasts for the UK are probably still a little too high, with house prices at best flat, the growth in retail sales negligible and the consumer paying down credit card debt, a rare event in the UK. The USA experienced a softer patch during the first half of 2005, but growth seems to be recovering to slightly above trend. The Eurozone with its tightly regulated economies and high unemployment (currently nearly 9%) seems to be locked into lower growth; the estimate of 1.9% growth in 2006 looks very optimistic, even with a weaker euro. Japan will probably achieve higher growth than consensus in 2005 and 2006, even if exports are flat, as the domestic economy is strengthening, with declining unemployment, rising consumer expenditure and continuing corporate capital investment. Further, China seems to have moderated the excessive economic growth of 2004 without causing a hard landing, by achieving over 9% growth in the first half of 2005.
3.The main threats to economic growth are the level of oil prices and the course of house prices, coupled with their impact on consumption. Although the developed world is far more efficient in the use of energy, particularly oil, than in the oil crises of the mid 1970’s and early 1980’s, the rise in oil prices acts as a tax on developed nations transferring wealth to the producing countries, which are in turn slower in spending increased revenues on imports. So a continuing high level of oil prices will impact growth. House prices have been very firm in western countries, particularly in the UK and USA, and this has helped to support consumer expenditure. However, house prices in the UK are soft and this, coupled with the very high levels of personal debt, have already impacted personal consumption, which represents two thirds of the economy. An actual fall in house prices, even modest, could have a larger effect on consumption.
4.Against this background, and with domestic inflationary pressures low (that is apart from oil) the UK interest rate cycle has probably peaked at 4 ¾% as the Bank of England has now reduced interest rates in early August by ¼% and by early next year rates could be down to 4%. Whilst this will help the corporate sector, the effect, apart from psychological, will be less on the housing market as the large stock of fixed rate mortgages taken in 2003 when rates were low will need to be refinanced at higher rates. So the help for the consumer of lower base rates may be less. UK interest rates will probably continue to rise from the current 3 ¼% to around 4%, which is reckoned to be neutral for the economy, while the Eurozone rate is expected to be held at 2%, but if growth continues to falter it could be reduced.
Markets
5.Markets have been awash with liquidity which, with rising confidence, has driven security prices. Central banks have maintained relatively accommodative monetary policies, despite rising interest rates in the USA, with money supply growing sharply. At the same time all governments have been running large budget deficits, which has added to liquidity, and has required rising sales of government bonds to finance them. The conundrum is why, with increased supplies of government bonds, yields have been so low. The table below shows their recent trend.
10 years Government Benchmark Yields
End March / End June / 8 August 2005UK / 4.7% / 4.2% / 4.4%
USA / 4.5% / 4.0% / 4.4%
Germany / 3.6% / 3.1% / 4.4%
6.At their low point yields seemed to be signalling a recession and in the UK the yield of 4.2% was well below base rates of 4 ¾%. Moreover the real yield (ie after inflation) was only 1% against the retail price index and so out of line with index linked gilts or 2% against the consumer price index. Although yields have risen since end June, they are still probably much too low and so bond prices too high.
7.In the meantime equities have been climbing the wall of worry and will probably continue to make progress in spite of slowing economic growth. The UK equity market is currently trading on a prospective end 2005 price/earnings ratio of 13 which historically is reasonable (the average over the last 10 years is 17.2) At this stage of the economic cycle one would expect companies to report earnings (profits) below expectations, whereas they have generally been reporting them above expectations and this is not just in the oil sector but more generally. Company earnings outside the oil sector are forecast to rise by 13% this year, so the prospect for continuing share buy backs and dividend increases is good. Moreover, private investors are still net sellers of equities and it would be abnormal for a market to peak before private investors were investing heavily.
8.The US equity market is not cheap in absolute terms or relative to bonds. Although corporate earnings are forecast to grow also by 13% putting the market on a price/earnings ratio of 16.1, this is only slightly below the 20 year average of 16.4, so the market has limited upside potential. European equity valuations continue to look reasonably attractive in spite of the rise in markets, with earnings expected to grow by 8% and price/earnings ratios around 13.4% for 2005 and 12.3 for 2006. Considerable potential still remains in the Japanese market. Companies have restructured so that corporate profitability and cash flow have improved greatly; the market could therefore, make further progress. The higher level of economic growth in the rest of Asia should support continuing progress in equity markets.
9.The US Dollar remains firm on the back of the prospect of a much reduced current account deficit and budget deficit. Sterling has fallen from a high of $ 1.94 to $1.73 before making a small recovery to $1.77. In the medium term sterling could fall towards the $ 1.65 level. Sterling has weakened similarly against the euro falling from euro 0.71 to euro 0.68 and could easily move down to the 0.66 level. The Japanese yen at 112 to $1 is grossly undervalued and could easily harden to the Yen 100 level, which, with possible further weakness in sterling, could take the yen/sterling rate down from the current yen 197 to yen 165 to £1. The Chinese revaluation of the renminbi by 2.1% will not end speculation on it moving higher, but rather increase it. This will probably lead to further upward valuations of other Asian currencies.
10.Charts of the UK and US stock markets and of currencies are attached.
A F BUSHELL
Independent Financial Adviser
August 2005
PF_AUG2605R05.doc