The Summer Recess

The summer recess

Bob Michaelson, Chief Investment Officer, Sagitta Asset Management
Originally published in the June/July 2005 issue

After a less than spectacular first quarter of 2005, April and May confirmed the view that most investors were slightly agitated, and a bout of poor returns from alternatives did nothing to improve the mood. We are now in the 'summer recess', where the proponents of sell in recent months have nothing much to sell at a profit this year and investors cannot really see out to the end of the year to see if prospects look brighter. It is worth noting that this is typical mid investment-cycle malaise, we are still on the road to recovery, and beneath the glum headlines, there are a host of interesting and positive developments to absorb.

The two locomotives of world economic growth, the USA and China, continue to provide a great deal of traction. There has been considerable concern that the US economy is wilting: talk of 'stagflation' is re-emerging and despite the fact that valuations for the S&P 500 are near ten year lows, investors feel in no mood to engage.

"The US domestic economy is not imperilled."

Investor concerns revolve around the potential for higher interest rates and lower earnings. Rates may edge higher, some earnings will decline, most will improve, not spectacularly but well in line with mid-cycle parameters. The US domestic economy is not imperilled, and exports are beginning to make headlines. Certainly the technology recovery of the previous two years had led to sumptuous valuations and that is being rectified, and whilst some 'energy' plays had also reached ridiculous valuations, there is no doubting that the exploration/demand curve for energy now greatly favours those who are involved in the upstream, midstream and downstream activities. Much, of course, of these endeavours are centred around the Texas panhandle and Western Canada.

China continues to be 'full on' with its economic expansion; we worry about the currency and inflation. But the doors to a higher standard of living and wealth have been opened to a voracious and hungry economic consumer; shutting the doors now is equally as dangerous as our aforementioned concerns.

We should probably take the benefits as they progress, because in reality there is little that can be done to influence the march of Sino-capitalist revolution from outside. The march has led quite a few serious commentators to suggest that such is the enormity and power of this secular change that the whole supply and demand picture for base commodities has now moved dramatically in favour of the supplier. Hyperbole is often the 'daily fix' of the financial commentators, but there is no doubting the attraction of the premise. World growth may be enjoying more of a push from the traditional empire building demand of the 19th century, than from the service led growth of the late twentieth century. Those who are not believers in cycles now have a powerful affront to their proposition.

With the two engines nicely at work we are inevitably drawn to those economies which may have veered slightly off the rails. We have pointed out for many seasons that Continental Europe has struggled to come to terms with many of the global changes. We have also indicated that this did not necessarily mean that stock markets were defunct, as there appeared to be many interesting changes appearing intra Continental Europe, particularly in medium sized companies. We must now add the UK to the list of those countries where we do have some 'macro' concerns. The rise in government spending is very worrying.

It is coinciding with a more reluctant consumer and a corporate outlook which looks more challenging. We anticipate that most of the positive news will now come from the larger companies whose more 'global presence' will mitigate against a potential downturn in the domestic market. A marked difference from the rest of Europe, but more a reflection of where the respective economies have been positioned over the last ten years.

Japanese economic forecasts will make schizophrenics of us all. One month of optimism is often followed by the reverse, dashing hopes that Japan is finally robust enough to re-emerge with a stable above trend growth pattern. The latest pronouncements suggest that the long wait may be finally over. Growth may have been expanding at an annualised 5.3% rate in the first quarter, way above previous forecasts, and whilst one Japanese sea-hawk doesn't make a summer, it is an intriguing and hopefully positive sign of things to come.

Equity strategies have not inspired so far this year, but there is sufficient positive news around to remain sanguine. The attraction of the Far East is well documented, the surprise may well be in the United States.

So far this year cash has been a tricky benchmark to overcome, particularly as alternative strategies have faltered in March, and April.

"There is nothing new in moments of extreme nervousness."

Long short strategies were challenged by days of ferocious counter trends, and could not escape from the general downturn in equities, whilst fixed income strategies became becalmed in headline making concerns over redemptions, GM and Ford trades going wrong, and an expectation that one of the major houses was in extreme difficulties. In one sense there is nothing new in moments of extreme nervousness. What is new is that the nervousness struck at the heart of an asset class which is meant to provide cash plus returns without a great deal of added risk. Recent events would certainly encourage us to raise the risk levels of the asset class, but in terms of the total portfolio risk, the increase is acceptable, as long as returns revive. The recent decimation of convertible prices, and the overdue widening of spreads, makes parts of these strategies much more attractive today.

Despite many dire warnings on the 'Real Estate Bubble', yields are being earned and capital appreciation eked out, not to the extent of the halcyon days of 2003 and 2004, but more than sufficient to confirm real estate as a continuing producer of above average returns.

"Fears expand as worries over interest rates ferment."

Inevitably fears expand as worries over rising interest rates ferment. We do not anticipate interest rates rising to punitive or discouraging levels at this time of the cycle. Real estate space is most needed in the area of greatest economic expansion. The opportunistic funds are usually best placed to take most advantage as prosperity and diversity of incomes evolve. Timber and oil and gas deserve their place in any current distribution of asset classes. The secular case for both is strong.

Private equity is in a relative sweet spot, as the three to five year vintage funds are reaping the benefit of the heightened acquisition and merger activity. Liquidity is readily available and given where we are in the cycle, this is just where we should expect private returns to make a major contribution. The flip side to this good news is that current investors are finding few bargains and the liquidity just adds to the sometimes indiscriminate frenzy to buy the quality opportunities. It is best to side with the strong names that have had most experience in these markets, and in all likelihood will still be shown the most interesting propositions first.

This part of the cycle can appear very tedious for investors, positive advances can be nullified quickly and vice versa, but normally markets will react to positive progress on the corporate front. We may well find that the USA and Asia fare better now than Europe. The alternate sector has had a second challenge, which this time has made some of the underlying strategies significantly cheaper, and we want the strategies to now show their merit. Meanwhile both private equity and real estate will provide a strong anchor to windward until other investors realise that the overall investment outlook is brighter than they are currently willing to acknowledge.