Market weakness could offer long-term investors buying opportunity

Alex Lyle, fund manager at Threadneedle Investments writes: Financial markets have seen significant volatility in recent weeks, driven by concerns over sub-prime mortgages in the U.S. and high yield debt in general. This could have an impact on economic activity, primarily through the housing market, if lenders become unwilling or unable to lend to lower rated buyers. More expensive debt for higher risk vehicles will also act as some sort of brake on the earnings of financial organisations. However, our economic model for the U.S. has always anticipated a slowdown in housing activity, and we do not regard recent events as being materially worse than we had expected. U.S. growth is no longer the driving force for the global economy, with rapid growth in China and many emerging economies, supported by a healthy recovery in Japan and core Europe. We therefore expect to see reasonable global growth combined with relatively low inflation over the next 12 months.

The expansion of spreads in investment grade and higher yield debt has led to a sensible re-pricing of these assets following a period when spreads had moved to extremely tight levels. We can see value appearing in some better quality investment grade names and, having significantly cut our exposure to high yield in the second half of 2006, we will be looking for opportunities in this market.

We have been overweight in equities in our managed funds and retain this position. We believe valuations are attractive with the current global P.E. ratio at around the lowest levels of the last 15 years. The UK dividend yield is well above the average for the last 3 years, despite an extremely low payout ratio, which gives scope for good dividend increases.

While markets are worried about debt it should be noted that it is not the quoted companies that are showing high levels of borrowing. It is individuals, highly leveraged hedge funds and private equity vehicles that are holding substantial debt. The 2 charts below show the high levels of interest cover for corporate U.S. and the strength of free cash flow generation. A similar picture applies in other global markets.

Furthermore corporate profits growth is strong. The Q2 reporting season around the world was encouraging with companies, on balance, beating expectations and leading to upgrades of forecasts. We have recently noticed a sharp rise in director buying of their own shares, showing the confidence they have in their businesses.

M& A activity has been a support for markets. Higher cost of debt for leveraged buyouts will undoubtedly reduce LBO activity. However this only accounted for 15% of global M& A activity in the last 12 months. There will still be demand for mergers from companies, funded by their own resources, shares or investment grade paper. Indeed many companies that we have spoken to are delighted that they will have better opportunities to make successful bids now that life will be tougher for the highly leveraged bidders.

Our funds, in general, have a bias towards high quality companies that can show reasonable growth. We believe these companies will be well suited to the current environment and a world of slower corporate earnings growth. We also favour a number of the more cyclical areas such as mining and industrials driven by Chinese demand and a global need for capex and infrastructure. We are relatively cautious on Western banks and Western consumer plays.

From a global perspective, our preferred equity markets are outside the U.S. In the latter the economic risks are currently greater than elsewhere and the scope for growth or corporate restructuring appears superior in Europe, Japan, Asia and Emerging Markets. We believe emerging economies and their companies are much stronger financially than historically and would regard any significant setback as a good opportunity to increase exposure.

The current correction may have further to go and is likely to depend on the extent of forced selling that has to be done to satisfy redemptions and de-leveraging. However we believe equities represent good value and the market weakness will offer long-term investors a buying opportunity.