2008 Outlook for International Markets (EAFE)
The top performing markets in 2007 were once again dominated by the emerging sector with Brazil up 75%, India up 74%, Turkey up 66%, and China up 63%. HGK funds benefited from their exposure to these regions as well as from the overall outperformance of the US markets by international peers, the world stock index rising by 5.24% in local currency compared to only 3.5% for the S&P 500. Confidence that global growth would continue to be firm despite the slowdown in the US explains much of this outperformance, as does the absence of the country specific problems associated with excesses in the mortgage credit markets. In many regions the direct link of monetary policy to the US Federal Reserve has meant that interest rates have been reduced at a time when the economies have shown no sign of slowdown. In Hong Kong for example mortgage approvals reached a record in November, up 76% compared to the previous year, a performance reminiscent of the early 1990s when US rate decreases prompted a surge in Hong Kong markets.
Richard J. Bruce
Chief Investment Officer
Bruce Nelson Capital LLP
Whilst the Asia-Pacific region was a strong performer, rising by 34% in 2007, Japan was a notable laggard, its stock market declining by 12% as concerns about an economic slowdown revived and political uncertainties undermined confidence that the authorities would be able to come up with the necessary solutions; the new Prime Minister, Mr. Abe, resigned after only 12 months in office, dragged down by evidence of management incompetence and weakness. Anxiety about the declining population was once again in the headlines as the birth rate fell to 1.09 million, the second lowest level in post-war history.
The European markets provided a mixed picture, led by Germany up 22% and held back by France which was up only 1.3%. For many years Germany has been restructuring its industrial base with initiatives from the government, employers, and the unions, and it is now reaping the benefit as its level of competitiveness has soared when compared to France and Italy. German unemployment has been declining and consumption has been firm even if in recent months there has been some waning of momentum, most likely the result of a squeeze on profitability from the strong Euro currency which rose by almost 10% against the dollar after a similar performance in 2006. East European markets have been a source of additional demand for the industries of the West, and the revival in the Russian economy as a result of higher oil and commodity prices has been a further bonus.
For the last 25 years US consumer spending has been increasing faster than consumer income and the savings rate has fallen from 12% to a negative 0.5%. This measure frequently has been criticised because it does not capture the overall wealth of households and so it can be misleading. However, in an environment where house price declines are accelerating and the inventory of houses is at record levels it is difficult not to come to the conclusion that the US economic deceleration is not over and that the remarkably resilient consumer spending will now start to decline.
The key, and fascinating, question facing global investors and corporate managements, as well as central bankers and economists, is the extent to which the emerging economies can continue to grow strongly in the face of a major slowdown in the US and can continue to provide critical earnings support for US corporations which are seeing declines in their domestic earnings. We believe that while the relevance of export earnings for US corporations is much greater than it has been previously, it cannot offset the impact of a severe domestic slowdown.
The US government by its acquiescence in the severe dollar weakness in the last 2 years has tried to force through an improvement in the competitiveness of its products, and to some extent this has worked, but the corresponding pressure on European and Japanese industry has negated much of the benefit for aggregate global demand. The G7 economies represent 70% of world GDP and are likely to slow in 2008.
International market Conditions
The abundance of cheap credit, low inflationary expectations, stimulative fiscal policies, secular emerging market growth, high commodity prices, exciting advances in technology and full employment in most markets have all contributed to a steady increase in asset prices in the last 5 years.
Housing has been one of the most obvious examples of this, with dramatic increases almost everywhere. Due to the leveraged nature of most ownership, the widespread diffusion of the asset class (more people own property and have a much greater share of their total assets in it than in either equities or bonds) and the tax-efficient structure of the investment, it is frequently at the forefront of consumers’ minds and the performance of this market segment underpins many spending decisions.
The evidence of the collapse in the US housing market – both in new construction and in prices for existing houses – is overwhelming, while the impact of the housing decline is only now beginning to be felt in the wider economy.
2008 is likely to bring much more pain in housing, which will carry over into the financial services industry, which until very recently, was a net hirer of employees, and is likely to make large numbers of employees redundant. There has not been widespread redundancy in the financial services industry since 1991.
Within global equity markets the anticipation of a downturn has been widely varied. In the Japanese stock market, for example, there was considerable weakness in 2007, and this followed mediocre performance in 2006. The historic premium of the Japanese market has now completely disappeared – the 16.5x price-earnings multiple for 2007 is exactly in line with that of North America. Some commentators highlight the discount that Japan trades on in price/book value – 1.7x compared to 2.8x in North America – but as the return on that equity has been consistently lower (10% in the latest year versus 17% in the US) the assertion that Japan should be rerated on a relative basis is flawed. Within non-Japanese markets there has been a very large fall in the prices of many financial stocks – particularly investment banks and mortgage lenders – as well as housing companies, so these clearly already discount a scenario of recession.
Many sectors however remain expensive on a global basis. The food, beverage and tobacco companies trade on an aggregate 20x 2007 earnings, household products on 23x, real estate on 22x and technology hardware on 19x.
The global 2007 price-earnings multiple of 15.5x was at this level only because of the financial and insurance sectors (11.5x), energy (13.6x), and materials (14x). The large sectors of the global equity market that are in denial about the threat to the global economy from the slowdown in the US are most likely to see the largest falls in 2008.
We believe that the Federal Reserve will be much more aggressive in easing policy in 2008 than it was in 2007. One overwhelming message from the Greenspan autobiography The Age of Turbulence is that the Fed really is on the side of the markets, no matter what public image to the contrary is fabricated. It seems almost as though the concept of moral hazard is ignored. On several occasions in the last decade a cut of 0.75% in US rates has been implemented. We think that cuts of this magnitude will come in 2008, and will potentially prevent major stock market weakness, even if they can do little to prevent the economy from moving into recession.
In 2008, we anticipate considerable price volatility, particularly in developed markets except Japan, where significant weakness has already occurred. Whether these movements occur within a declining trend or whether stability will be restored and the year-end indices will be higher, will depend largely on how rapidly and to what extent central banks reduce interest rates.
In Japan virtually nothing can be done as the rates are already at extremely low levels, a legacy of the fight against deflation. In Europe the head of the European Central Bank, Mr Trichet, is very aware of the pressures on the global economy and the tone of his recent statements has been increasingly pessimistic, but he is also concerned about the dangers from rising inflation where indicators have been deteriorating in recent months. Much, therefore, will be determined by the Fed, and here we expect major moves. In 2007 there was no major surge in corporate bankruptcies but in the last months there were signs that the weakest players were starting to fall: Maxjet, a pioneer of low cost business air travel between the US and the UK filed for bankruptcy only months after its listing as the burdens of higher energy prices and an absence of credit undermined its profitability and balance sheet.
Our Conclusion
In 2008 there will be excellent opportunities to buy companies at depressed valuations. Our initial and tentative steps have started: we have acquired some new holdings in Japan and also in Merrill Lynch, a heavily sold-off financial in the US. We may be early in some cases but we expect that the participation of hedge funds will push stocks which disappoint to low levels faster than in previous cycles.
Richard J. Bruce
Chief Investment Officer
Bruce Nelson Capital LLP
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