Market commentary


Quilter market commentary E


NIGEL CRAWFORD, HEAD OF QUILTERʼS BELFAST OFFICE PROVIDES US WITH THE VIEWS OF DUNCAN GWYTHER, QUILTERʼS CHIEF INVESTMENT OFFICER


vidence ‒ most recently from the higher growth emerging economies ‒ that global economic activity is slightly below expectations has increased risk aversion across all financial markets. The FTSE 100 fell 417 (7.3 per cent) in May to end the month at 5,320. The S&P 500 was down six per cent but is one of the few indices to be higher (+4 per cent) than it was at the start of 2012. Emerging market and European indices fell seven per cent and eight per cent respectively with the latter hit by fears that continuing political uncertainty could lead to another bout of systemic risk in the eurozone. Defensive sectors/stocks like telecoms, utilities and healthcare tended to outperform cyclical industrials and financials. The flight to perceived 'safe haven' assets ‒ US Treasuries, German bunds and UK gilts ‒ meant yields on 10 year bonds touched record lows of 1.56 per cent, 1.24 per cent and 1.57 per cent respectively. Commodity prices dropped over 10 per cent in May and Brent crude at $99.28 was almost 25 per cent off its 2012 high which is helping ease inflation pressures. US manufacturing ‒ especially autos ‒ is still expanding but lower employment growth has dented consumer confidence. Housing has received a weather‑related boost while low interest rates and improved affordability indicate that over time there should be a gradual improvement. The news will increasingly be dominated by the presidential election, gridlock in Congress and the looming 2013 'fiscal cliff' of legislated tax increases. Japan's recovery continues with improvements in business sentiment, core machinery orders and domestic demand although exports to the rest of Asia are weakening.


Modest GDP growth of two to three per cent in the US and Japan is being offset by Europe. UK estimates are being downgraded and 2012 may now see a small GDP contraction mainly reflecting prolonged eurozone weakness. High levels of UK household debt will also constrain growth but there is better news on inflation while the relentless squeeze from government austerity measures means the fiscal deficit is on a declining trend. Every major eurozone economy ‒ bar Germany ‒ is in recession with the outlook deteriorating significantly in Spain and Italy. Better than expected Q1 growth in Germany has raised 2012 eurozone GDP estimates marginally to ‑ 0.6% but the escalation of the crisis will hinder German exports and result in lower 2013 estimates of around ‑0.7 per cent. Although the Irish fiscal deficit improved in 2011, the outlook remains fragile. With the economy likely to slip back into recession this year and high levels of debt, Ireland could join Portugal in needing further restructuring. After an improvement in activity data in


March, Chinese exports, industrial production, fixed asset investment, retail sales and Purchasing Manager Indices have all weakened again which is consistent with GDP of nearer seven per cent than eight per cent. PMIs have also fallen in Singapore and Taiwan and dipped below the 50 'boom/bust' level in Brazil and Poland. Industrial production and exports were weak in Taiwan while Indian exports turned negative for the first time since 2009.


As inflationary pressures ease ‒ and most economies have ample scope to respond to the cyclical slowdown ‒ we expect further measures to boost the outlook for financial markets during the second half of 2012. China has recently cut interest rates as well as reduced bank reserve requirements and selectively targeted loan growth towards small/medium size enterprises. Brazil and Australia have also cut rates and others may follow.


Political leadership may be lacking but most commentators agree on the five steps to 'euro heaven'.


First, the ECB has to take more aggressive action ‒ possibly by extending the term of its repurchase facilities and reducing collateral requirements as well as outright quantitative easing via purchases of private and public sector bonds.


Second, troubled commercial banks in the peripheral countries need to be recapitalised perhaps using the ECB/eurozone central facilities.


These steps are relatively easy to achieve in a short time frame and could buy time to introduce the third one ‒ a pan‑Euro federal deposit guarantee scheme.


The fourth and fifth steps are fiscal union and empowering the ECB to act as the official lender of last resort for federal Europe. These are more problematic as they require widespread political support as well as constitutional and EU treaty changes. Faith in the euro could be severely tested if there is another inconclusive Greek election in mid‑June. Greece is likely to miss the targets laid down by the EC, ECB and IMF which would present the EU with three options ‒ continuing to fund it, sanctioning a disorderly exit or allowing Greece to exit at say the end of 2012 but managing the process by aggressively ring‑fencing other countries using some of the measures outlined above. Unfortunately, lack of progress even on measures already agreed ‒ specifically the European Stability Mechanism (deadline 1 July) and Fiscal Compact (deadline 1 Jan 2013) ‒ means markets are likely to find themselves on the edge of the confidence precipice every step of the way.


Investors continue to sell equities and buy


bonds. While from a long‑term valuation perspective this doesn't make a great deal of sense, it is understandable for institutional investors who are forced buyers of bonds. For less constrained investors, current valuation levels increase the likelihood of long‑term opportunities for maintaining or enhancing capital in real terms. UK equities are trading on a P/E ratio of 10x assuming six to seven per cent earnings growth in 2012 as against a long‑term average of 12x.


There are two ways of looking at this. If earnings estimates are correct, the market would need to rise over 15 per cent to return to its long‑term average valuation. Alternatively, if the earnings outcome is valued correctly, this implies a five per cent fall in profits this year. Sentiment may be very depressed but there is little to suggest that profits will fall let alone by this magnitude. Meanwhile, the prospective dividend yield of four per cent is substantially above the return on bonds and higher than inflation. Investors have faced structural uncertainties before but companies have generally adapted well and we see no reason why this shouldnʼt be the case this time.


This communication is directed at and is intended to be viewed by investment professionals only (as defined in Article 19 of the Financial Services and Markets Act (Financial Promotion) Order 2005) and must not be acted on or relied upon by any other person. Any investment or investment activity to which this communication relates is available only to investment professionals and will be engaged in with investment professionals only. Investments or investment services referred to may not be suitable for all recipients. Quilter is the trading name of Quilter & Co. Limited, a private limited company registered in England with number 01923571, registered office at St Helenʼs, 1 Undershaft, London EC3A 8BB. Quilter has established a branch in Dublin, Ireland with number 904906, is a member of the London Stock Exchange, is authorised and regulated by the UK Financial Services Authority, is regulated by the Central Bank of Ireland for conduct of business rules, under the Financial Services (Jersey) Law 1998 by the Jersey Financial Services Commission for the conduct of investment business in Jersey and by the Guernsey Financial Services Commission under the Protection of Investors (Bailiwick of Guernsey) Law, 1987 to carry on investment business in the Bailiwick of Guernsey. Accordingly, in some respects the regulatory system that applies will be different from that of the United Kingdom.


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