October 2008

US EQUITIES: Once Upon a Time ...

Financials may be toxic, but there are still sectors that may attract investors to US equities, finds Fiona Rintoul ... “What all the investment banks on Wall Street need to do now...” My interlocutor pauses a moment and reconsiders: “What am I saying – all the investment banks? There’s only two left!”

A couple of days later there were none left as Goldman Sachs and Morgan Stanley changed their status to bank holding companies. No doubt about it, then, these past few weeks have been a momentous time for Wall Street and the wider financial world.

At the same time, the US is still the largest investment market in the world and some people, many people, have portfolios of US equities to run. Even if the world is melting down around them, these fund managers need a strategy. They need to find a way to evaluate what is being called the biggest financial crisis since the Great Depression. Very tricky. And they need to try and see beyond the crisis. Even trickier.

A problem they face when making these evaluations is knowing whether to trust both in their own judgement and in that of their advisers.

“If you’d told me a year ago that Bear Stearns, Lehman Brothers and Merrill Lynch would not longer be there as independent firms, I’d have laughed in your face,” says Simon Ward, chief economist at New Star Asset Management.

We didn’t see this coming, so how can we know what’s coming next? Well, we can’t really with any certainty, not least because this crisis is different.

“I don’t think it will be like past crises,” says Ward. “Governments around the world have assumed huge amounts of credit risk. Because they are now bearing that risk they will be more involved in the financial markets. We will have a much more regulated system in future, much less entrepreneurial. Credit conditions will probably not return to the way they were for
a generation.”

Almost everyone is in accord on these two points: government will be more involved in the finance industry in the future and credit conditions will be tighter.

“When we come out the other side, there will be more regulation and less leverage,” says Andrew Holliman, head of US funds
at Threadneedle.

That may bring its own problems – and there’s always the danger of throwing the baby out with the bathwater – but it’s for the future. What about right here, right now? What’s to do?

Once in a lifetime
The first source of consolation for someone running a portfolio of US equities, or any other portfolio for that matter, is that this probably won’t happen again. The earthquake may not yet be over – there is almost certainly more pain to come – but none of us is likely to experience a financial tremor that scores this high on the Richter scale ever again.

“It’s very clear that this is something you only see once in a lifetime,” says Mark Stoeckle, the Boston-based CIO for US equities at Fortis Investments. “It’s unprecedented and frankly unnerving. And I still believe we’re not finished. There’s a lot of bankruptcy to come focused on smaller players.”

Which means things can only get better – kind of.

“I think there’s more bad news to come,” says Simon Moss, investment director on the US equities team at Scottish Widows Investment Partnership (SWIP). “Credit default swaps worry me a lot. But markets always look forward. I wouldn’t be surprised to see a year-end rally, though from a lower base than now, and if you look at 2009, you think it can’t be as bad.”

Indeed, there are some who think the crisis is being a little over-played. Hubert Goyé, head of  international equities at BNP Paribas Asset Management, cites the example of the Japanese crisis of 2002-2003. A lot of big banks in Japan were close to collapse, but a couple of years later a lot of those banks had repaid their debts.

“We’re not too far from that,” says Goyé. “It’s very difficult to judge the depth of a crisis when you are in it. Remember 1987? When you look at the charts now you can hardly see it. We need to wait and see because there are more connections between markets nowadays, which is both good and bad.”

Hope is at least permitted, he suggests.

Another consoling factor is the sheer size of the US market. Attention may currently be focused on the ‘toxic’ finance sector, but there are plenty of other sectors out there that are doing just fine.

“The great thing about the US is that there are up to 1,000 stocks,” says Holliman. “There are more places to hide than in many other markets.”

The property problem
Of course the risk of contagion is there in other sectors, as it is in other countries, particularly those such as the UK that are driven by similar factors to the US and have a similar (and, in the case of the UK, more extended) housing problem. Stoeckle points out that the US economy has always been based on the availability of credit and Goyé notes that industrial companies, for example, will also suffer from an unwillingness to lend, so “we don’t know where the next problem will be”.

But for Holliman’s money there is still a high number of companies in the US with strong global brands and balance sheets, and strong franchises that will generate good cash flow.

“We still see good opportunities to make absolute money over the next three  years,” he says. “What we like about the US is that it has many companies that are extremely well-run – more so than other markets – and flexible labour markets.”

Another positive factor is that the US went into this first and so may come out of it first. “That’s what we’re hoping,” says Moss, who points out that over the past nine months the US market has outperformed other major equity markets.

The key, he says, is the housing market. “We will see the US housing market bottoming. There’s a reversion to normal lending standards. They were disciplined, but the discipline went. They’re now starting to lend more conservatively. Sense has come back to the housing market, but it will take time to work through.”

The fact that this process has now begun puts the US in a stronger position than, say, the UK, where the housing market is just starting to unravel and where consumer debt is also likely to be a bigger problem than in the US. Like Holliman, he still sees good opportunities in the US market.

“Ultimately, it’s quite a resilient economy. There are some very good companies. The world will continue to drink Coke and to
use Colgate.”

Moss also favours infrastructure and technology stocks, which are insulated from a fall in domestic consumer spending, though he is less pessimistic on consumer spending than some because he believes it will be boosted by the falling oil price.

Long-term focus
“Power stations will still need to be built and the Middle East still wants infrastructure,” Moss says. “If you look at Cisco, it’s equipping planned new cities in the Middle East with the Internet and other connectivity. It’s a world leader and will continue to do well.”

Goyé also favours tech and infrastructure stocks because they are export-driven, but he’s also overweight in defensive stocks, such as healthcare.

“We have very limited visibility,” he says. “We tend to favour stocks which should have good resilience whatever the economic scenario. The US economy will slow, but those guys are reactive. We focus on the long-term, on what will happen beyond the current turmoil.”

It’s still possible to find value, then, though there are certainly no easy answers at the moment, not least because we are in a new scenario.

“It’s a harder job to find opportunities,” says Holliman. “This is different from the average economic cycle because the consumer has to rein in spending. Coming out of this cycle we’ll see below-trend earnings growth for a few years, but that doesn’t mean the stock market won’t produce returns.”

As for the troubled financial sector, Goyé suggests that the worst is over with the number of companies that may yet fail being “relatively small”, while Ward predicts that when we come out of the crisis the financial sector will have shrunk, the survivors will have a more sustainable business model, and “lots of sophisticated derivatives will disappear”.

A very different landscape, then, though Fortis’s Stoeckle is quick to point out that reports of the death of financial innovation may have been exaggerated.

“The use of leverage will have to be curtailed,” he says. “It will happen and it should happen. But will we be plain vanilla forever? Certainly not. Financial engineering is part of Wall Street. If anyone thinks this spells an end to innovation, they don’t understand Wall Street.” ©  2008 Funds Europe

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