Market View
February was a curious month. St Valentine’s
Day came and went with no widespread massacres either in the
deserts of Iraq or indeed on the equity markets. Bulls tried
to take some comfort from the emergence of a couple of high
profile contested bids, notably at Six Continents and at Pizza
Express. But the general feeling was that in both Iraq and
on the markets the pain was merely being postponed.
A decent results season from the banks and
an oil sector boosted by the strength of crude meant that
the FTSE 100 actually gained ground on the month: rising by
0.98 per cent to 3,625.34 between 4 February and 4 March.
While the banks – as a whole –
made positive noises about dividends, the same could not be
said for the insurers. And with equity markets still, essentially,
in a downward trend their balance sheets are bound to deteriorate.
The insurers plus the cyclical stocks, for whom recovery is
becoming an ever more distant prospect, were the big losers.
The FTSE 250 fared less well than the blue
chips principally because it has very limited exposure (by
weighting) to banks and oils but is far more exposed to the
cyclicals. Over the month to 4 March it rose by just 0.14
per cent to 4,052.55. The biggest casualties were again the
small caps. If you need a true guide to investor sentiment
look at the general aversion to illiquid stocks. Over the
four weeks to 4 March the AIM Index fell by 2.79 per cent
to 561.41.
Case for a rally?
As I write the countdown to war is intensifying. Cabinet ministers
are threatening to quit and there is no doubt that geo-political
tensions are making the equity markets jittery. But within
a month it is perfectly plausible that Gulf War II will be
over. Conventional wisdom is that whilst equities fall in
the run-up to battle as soon as it becomes clear that the
battle is won – or about to be won – equities
rally. Er…maybe.
If the Iraq situation is resolved one way
or another there may well be a ‘relief rally’
but to pretend that the weakness of equity markets over the
past few months is all down to Saddam/Bush and Blair is, I
am afraid, to ignore very real problems elsewhere.
Economic data on both sides of the Atlantic
suggests that at long last consumer confidence is starting
to crack. American jobs data for February, though affected
by a number of one-offs was very poor. However one views the
numbers the loss of 92,000 retail jobs in one month alone
backs up data on consumer confidence which suggests that at
last the citizens of Main Street USA are starting to worry
about high levels of personal debt, job insecurity as well
as problems abroad, and is reining in its spending.
In the UK there are similar signs, not least
the way that the fall in house prices is starting to spread
from London hotspots to other parts of the South. Historically
the ‘Chelsea ripple’ spreads across the UK - and
never bet against history repeating itself whatever Estate
Agents try to tell you.
Industrial crisis
If consumer spending is faltering, industrial investment remains
in the doldrums. The Authorities must hope that the weakening
of the dollar and the pound when combined with low interest
rates will kick start the industrial cycle. But so far there
is no sign of this happening. And in the UK a raft of tax
rises on employers and employees in April is unlikely to help
the situation. Thanks Mr Chancellor of the Exchequer. Meanwhile,
with crude now trading at $33 a barrel, increased energy costs
are putting an added squeeze on margins.
The bottom line is that the outlook for corporate
earnings growth in both the UK and the US does not look particularly
rosy. Those who had been banking on a significant uplift in
earnings in the second half of this year now look likely to
be disappointed. Bulls hoping for an improvement in earnings
must now be starting to pin their hopes on some good news
coming through either in the final quarters of 2003 or, more
realistically, in 2004. Recovery may well have been postponed.
If you are a bull you can attempt to argue
that much of this bad news is already discounted. After all
the FTSE 100 Index is now more than 50 per cent down from
its peak levels. Whilst remembering that really savage bear
markets (Japan in the nineties or the USA post 1929 being
prime examples) see values falling by 90 per cent, there are
some reasons to go along with the bulls…at least some
of the way.
The most compelling reason to buy UK equities
is now the yield. Despite changes in the tax system that makes
dividends a relatively unattractive way of returning capital,
the prospective yield on the FTSE 100, at around 4 per cent,
makes equities look more attractive when compared to bonds
than at any time for more than 30 years.
The key question is whether one has any trust
in the prospective yield. Bulls point out that with gearing
at UK PLC down to 37 per cent (well below levels in Euroland
and the US) British industry faces no immediate cash squeeze
and indeed could afford higher gearing given the outlook for
base rates. Moreover, average dividend cover of just over
1.5 is acceptable for this point of the cycle.
Bears argue that although the vast majority
of blue chips reporting so far this year have either maintained
or increased their payout they are doing so in many cases
not because it is prudent to do so but merely because their
institutional investors have demanded it of them.
If earnings fail to increase over the coming
12 to 24 months or – heaven help us – actually
fall, then dividends will have to be cut. If the average corporate
is paying out two-thirds of retained earnings in dividends
then the implication is that, even a modest reduction in cashflows,
will leave a good number of companies financing dividends
via increased borrowings. That is not a recipe for long-term
success.
I suspect that most blue-chip dividends are
safe and that is why on a long-term view UK equities probably
represent good value. But that is not the same as saying that
there will not be further short to medium term weakness as
some rather shocking dividend horror stories emerge.
Tom Winnifrith edits the financial website
www.t1ps.com
REFS is
a mine of invaluable information for the private investor.
