New Year's View
As we look back at 2007, it's easy to be reminded of the words of Warren Buffet, the guru-like American investor and billionaire, who said that it's "only when the tide goes out do you discover who's been swimming naked". The nakedness that Buffet refers to is the investment risk people have been taking when times are good, only for it to be revealed when markets take on a less benign affection.
It is possible, perhaps, that the tide has not fully withdrawn; and that there are those further from shore who's risk taking has not yet been fully exposed. Concentrating solely on the stock market for a moment, there will be investors who may be finding it hard to reconcile the performance of their portfolio with the negative news flows in the media; or conversely, who may be looking at the negative return on their investments, relative to the recent level of the FTSE.
At the start of the year the FTSE 100 stood at 6,310.93 (02/01/07), and at the end of the year (31/12/07), the FTSE 100 was at 6,456.91: a modest gain of 2.3%. Over the same period, the IMA UK All Companies Sector, which is an amalgam of UK registered UK growth funds, could only manage 0.5%. Meanwhile the IMA UK Equity Income Sector, which is composed of income producing funds and therefore tends to be biased to more defensive, blue-chip companies that pay good dividends, fell -3.8%. Even if dividends were reinvested, the IMA UK Equity Income Sector fell –1.8%.
What this shows is how unrepresentative the FTSE 100 Index (and indeed the FTSE All Share) is of most UK stocks. The reason for this is that the value of the FTSE 100 and FTSE All Share are both calculated by the market capitalisation of the constituents. Consequently, the largest companies have a far greater effect on the movement of the index than smaller stocks. In the UK the largest stocks happen to be disproportionately mining, telecoms and oil & gas companies: sectors that have done extraordinarily well over the last 12 months.
UK equity funds that appear to have held their heads above water over the last 12 months, have by and large, been those with a healthy weighting to the mining sector. Tracker funds also, which are obliged to hold stocks proportionate to the index, have also done relatively well, compared to many of their actively managed counterparts. Whether this is set to continue through 2008 largely depends on the view you take with regards to the so-called commodities 'super-cycle'.
According to the super-cycle theory, we are witnessing an historical one-off, as emerging economies like China, demand more and more of the world's finite resources. Not only is the infrastructure not there to supply this demand fast enough, but also the demand itself, keeps growing. The demand driven price rises that began in the metals and raw materials sectors, have now spread to the so-called 'soft commodities' like wheat, sugar and cattle, as diets and consumer preferences change in emerging market countries. Indeed, this is quite a powerful argument. It is hard to disagree that China (in particular) is going to play an increasingly powerful role in the global economy. So long as China keeps demanding raw materials to fuel it's economy, commodity prices will continue to rise, right?
Well, it may not be as simple as that. In Europe and the US, we are worried about slowing domestic economies; but in China, the government is worried about the exact opposite: runaway domestic growth. Chinese efforts to control growth have not just been limited to the Shanghai Stock Exchange, but also to the economy as a whole. Development on a massive scale is creating huge social and economic pressures within China; pressures that the Beijing government is nervous of. As western demand for goods manufactured in the Far East declines, as our economies slow, so too will the demand for the raw materials that produce these goods lessen. At the same time, several major construction projects will be coming to an end (not least of all the Olympics in summer 2008). All of this raises some doubt as to whether the super-cycle is sustainable, at least in the short term. Added to this is the effect the futures market has on commodities trading, and the degree to which the prices may be inflated to start with.
Finally, there is the fact that at a stock level, a danger exists that many mining stocks could be overvalued. In September this year, for example, a company entered the FTSE 250 (an index of the next 250 largest companies in the UK after those in the FTSE 100), whose principal concern is owning a large plot of land in Finland, under which lies a significant amount of sulphide nickel. It will be late 2008 until any nickel is extracted. Speculation is not necessarily a bad thing, but with so many investment funds weighting themselves against an index, you can quickly get a snowball effect.
In short, investors who are still out to sea, and laughing at those caught by the tide, may find that it's an awful long way back to shore from where they are when the tide reaches them too. At which point, taking a defensive stand early in 2007 and getting caught early (as many equity income funds, in particular, have) could turn out to be a sensible option.
Away from equities, 2007 may end up being remembered when the worm turned for UK property. The decrease in demand for commercial property has been helped by the addition of new and upgraded property on the market (especially in London and major cities); but it's residential property that has will likely occupy the headlines. Barring exceptional data for December, the last 3 months of 2007 are likely to show a slight fall in the value of housing.
We have seen many years of successive rises in UK residential property but this has been achieved during hollowed times. Cheap debt, record levels of employment, high immigration and changing demographics have contributed to demand outstripping a supply that simply couldn't keep up. Demand and supply, however, normally work at a fairly marginal level, meaning that even a small fall in demand can have a significant effect on prices. Over the short term the combination of more costly debt, potentially higher unemployment, slowing immigration and the major significant demographic changes behind us (in addition to more new properties being built), we might well expect UK residential property to pause for breathe during 2008. While we may see prices fall, property slumps tend to happen over a 2-3 year period and generally see a drop by around 20%. This is obviously no comfort to those at the sharp end, but individuals tend to hold property assets for longer periods of time; and in the UK, many of the fundamentals that have underpinned the property boom of recent years, could well soon return.
Looking into 2008, it looks like the easy money is behind us for the time being, but that does not suggest a reason to go away. In the same way that the run down end of terrace house, in an otherwise good locale and neighbourhood might still represent a good buy, so too is there value to be found in the stock market. Defensive stocks, with good and dependable cash flows are likely to be the order of the day; and if not, then, as we've said a number of times over the last 6 months, there's always bonds!
James Davies - Chartwell Investment Research Manager
