Shakeout fails to stir positive equity market forecasts at Threadneedle

In the wake of last week’s market turbulence, Threadneedle examines the drivers behind the upset and its fund managers outline their forecasts for global equity markets.

Equity markets around the globe suffered a shakeout last week amidst a severe bout of risk aversion, as financial, as opposed to economic, concerns prompted investors to lock-in profits and seek out safe-haven assets such as government bonds. The exception was China where the equity market continues to defy gravity.

Jeremy Podger, Head of Global Equities and manager of the Global Select Fund, comments: “We’ve had shakeouts before in this bull market, principally in May 2006 and again in March this year. These were prompted by concerns about economic risk – in the case of the former on the back of an inflation scare in the US and the latter prompted by uncertainty about US economic growth. These were soon shrugged aside as the fundamentals reasserted themselves, helped also by a frenzy of M& A activity.

“However, the latest upset has resulted from an increase in financial, not economic, risk and started in the credit markets. This had initially surfaced in the subprime (or low quality) mortgage market in the US where the number of defaults has been on the increase, adding to concerns which already existed about the slowdown in the housing market and the impact it could have on consumer sentiment in the US – the US consumer accounts for 20% of global consumption. However, the equity market had shrugged aside the subprime issue as a local concern and unlikely to spread contagion into the wider credit market. This optimism was dented slightly recently when Bear Stearns, the American investment bank, announced that two of its hedge funds were virtually worthless as a result of subprime investments.

“But as the markets’ mood turned sour last week, prompted by a widening in credit spreads, albeit still at low levels historically, this raised fears about a withdrawal of the liquidity which has been helping to drive the markets. Last Tuesday, the chief executive of Countrywide, which is the biggest mortgage lender in the US and a closely watched bellwether of market conditions, announced a big drop in profits and stated there was evidence that the subprime woes were spreading into the prime mortgage market. Shortly after came the news that the investment banks behind the debt-financed buy-outs of Alliance-Boots and Daimler were having difficulty finding buyers to take the debt off them, heralding in many eyes the end of the leveraged buy-out and takeover boom which has provided such a big spur to markets over the last couple of years. This compounded the news earlier in the week from Expedia, the online travel agency, that it had reduced plans to buy-back its own shares because the recent rise in bond yields had made the funding costs unattractive.

“We have been anticipating a summer market correction for some time and accordingly have been adopting a more defensive stance across our portfolios. This has varied by region but has generally taken the form of increasing exposure to large cap stocks, adding to consumer staples, reducing our bigger positions, such as industrials, underweighting the retailers and financials – the latter have suffered in particular - and holding some cash. This stance has generally paid off for our equity funds, which have been performing well this year, and the market correction has been used as an opportunity to pick-up some of our preferred stocks at cheaper levels.”

Today, our equity fund managers reiterated their positive view on markets, pointing out that the economic backdrop remains strong and that the second quarter earnings season has generally exceeded expectations. It was pointed out that there is no evidence the current bullish phase in equity markets is coming to an end.

Chris White, manager of the UK Growth & Income and Pan European Equity Dividend funds, feels what is happening is about normalisation - the end of the cheap money era with interest rates, bond yields, inflation expectations and credit spreads returning to more normal levels. “While there is no need for panic, the risk lies with continued weakness in the US and some European housing markets, such as Spain and Ireland. The key to global stock market confidence lies with the US consumer and if the US economy performs well then so should the rest of the world. There is scope for central banks to ease monetary policy to provide support if necessary and this would be likely to take the form of positive commentary rather than an actual change in rates, but could mean rates in the UK may not rise further.”

Steve Thornber, manager of the Global Equity Income Fund, sees a continuation of current themes and risks, but that these have heightened. “The problems equity markets are facing are financial, not economic, and therefore they should not have a long term impact. However, the current situation is all about sentiment and if the worries deepen they could undermine economic activity which in turn could undermine growth and thereby equity markets. But equities still represent good value relative to bonds and history, they are supported by attractive fundamentals and therefore should be able to withstand the problems in the debt markets.”

Vanessa Donegan, Head of Far Eastern Equities and manager of the Asian fund comments that “risk premiums have been raised across the world causing volatility in Asian markets. These have risen strongly this year and investors are sitting on profits which are a relatively easy sell if they need to cover positions elsewhere. Fundamentally, nothing has changed in the region - economic growth remains robust and companies are delivering strong earnings growth. Therefore, we would regard any falls in markets as an opportunity to add to holdings on a medium-term view.”

Cormac Weldon, Head of US Equities and manager of the American Select fund, points to initial reports just in for Q2 US GDP which grew at a better-than-expected 3.4% annualised. “Nevertheless, we are not complacent and we will continue to look out for any signs of an economic slowdown. Speculative stocks have suffered a setback, as a potential source of funding has been withdrawn. However, we are sanguine about this as investing in takeover situations has never been part of our strategy. Also, we have been underweight banks and financials, the largest market sector and another area which has suffered. Our funds remain orientated towards quality growth companies with visibility of earnings, which we believe will continue to deliver performance. Even in the midst of the current turmoil in markets, it is reassuring that attractively valued companies which produce good earnings numbers are being rewarded by the market. Examples of these in the Q2 reporting season include Apple, Crocs and Republic Services Group, all significant positions in our portfolios and which have seen their share prices rise after reporting earnings.”