Charles Robertson: Are there actually reasons for investors to be cheerful?

During the traditionally-quiet summer months, concerns about the European debt crisis and global economic growth increased until equity and credit markets around the world fell sharply in August.

While many will see the current wave of pessimism engulfing investors to signal the resumption of the “bear market” that started in 2008, are there actually reasons for investors to be cheerful?

Although the European sovereign debt problems took centre stage, the catalyst for the market falls was a series of disappointing US economic indicators. As a result, investors began to re-asses the macro-economic risks and fears mounted that western economies may fall back into recession and, more worryingly, may enter a period of deflation. However, although gross domestic product (GDP) forecasts have been lowered the International Monetary Fund (IMF) is still forecasting that advanced economies will next year deliver real GDP growth of 2 per cent, with developing economies growing at 6 per cent.

Confidence weakened further as political wrangling engulfed the authorisation to increase the “debt ceiling” in the US and as Standard & Poor’s downgraded its credit rating. Investors’ fears have intensified as the Federal Reserve embarked on a new strategy, dubbed “Operation Twist”, having stated ‘’there are downside risks to the economic outlook’’.

In Europe, an “orderly” solution to the sovereign debt problems that satisfies both an increasingly-intolerant electorate and nervous investors is proving elusive. However, I consider this will be achieved because failure “is not an option”. While the direct economic effect of a Greek default would be largely localised, the ramifications for the European financial institutions that hold Greek debt could be severe. Of greater concern are the signs of contagion in the sovereign bond markets of Spain and Italy.

UK economic activity has also slowed and become increasingly patchy. Growth rates are well below the levels experienced following previous recessions although this recovery is unusual, set as it is against the background of a recent financial crisis. With the banking system under heavy regulatory pressure to increase capital adequacy, lending has not started to rise as would be expected at this stage of the recovery cycle. However, the financial sector is in a stronger position than in 2008 as a result of the significant capital raising exercises undertaken. At the same time, the UK government is focused on reducing debt and “balancing the books” through increased taxation and austerity measures. Equity and credit market volatility will, therefore, continue to make life difficult for investors but – looking through the peaks and troughs that this causes – there are indeed reasons to be cheerful.

UK PLC adjusted rapidly to the financial crisis of 2008 and companies are in a stronger position as cash on balance sheets and debt to equity ratios have improved. Therefore, analysts are forecasting that the majority of companies will be looking to increase their dividend payments over the next two years.

In terms of valuation, the market is also in a very different position with the 12-month forward price-to-earnings ratio and trend adjusted price-to-earnings ratio both at a significantly-lower level than in 2008. The gilt-to-equity yield ratio is in positive territory, which is also traditionally seen as being a “buy signal”. It is highly significant that directors of a broad range of companies are not seeing investors’ pessimism in the actual performance of their businesses and this has been reflected in the buy-to-sell ratio of director share purchases, which moved sharply higher during the summer months.

Overall, the global economy is unlikely enter into a full recession, although growth will be at subdued levels, particularly in the west. Accordingly, I continue to favour being overweight in higher-yielding, financially-strong equities with good international franchises, which appear to be attractively valued when compared to the elevated prices in government bond and the negative real rate of return offered by cash. In addition, equities have the potential over the longer term to combat the likely increase in inflation that will arise as a result of the fiscal and monetary policies employed. Therefore I would “buy the dips” and not sell “the rallies”.

l Charles Robertson is senior investment manager with Murray Asset Management.