“Green shoots”- will they blossom into a recovery?

Spotting “the green shoots of recovery” is a popular pastime of government ministers when looking for good news in the midst of recession. Norman Lamont, the Chancellor of the Exchequer in 1992 and, more recently this year, Baroness Vadera, the Business Minister, were both derided for seeing early evidence of recovery when news about the economy was terrible. Had they lost touch with reality?

Looking for “the green shoots of recovery” is not just for government officials. It is important for investors too as they look for new investment opportunities. Stock markets have risen sharply over the last few months as investors have turned from worrying about a long lasting deflationary slump in economic activity to thinking about the potential for recovery.

Over the winter months investors were seriously concerned about the potential for a deflationary slump as the sharp reduction in bank lending (“the credit crunch”) caused individuals and companies to cut back on spending. This had the potential to create a downward spiral in activity with falling demand leading to job losses and further cutbacks in spending. However, governments recognised the problem taking co-ordinated action to increase their spending to help fill the gap in activity. Central banks, such as the Bank of England, cut the cost of borrowing and introduced policies such as quantitative easing to increase the amount of money in the economy. Measures were taken to strengthen and support the banking sector with the UK government taking stakes in Lloyds Banking Group and The Royal Bank of Scotland.

The good news is that the “green shoots” of recovery are emerging. Business and consumer confidence has increased, financial conditions have improved and property markets have started to bottom out. The bad news is that –

• we are not yet seeing much evidence of improving conditions when we speak to the companies that we invest in
• all three of these areas ( confidence, financial conditions and property markets ) are crucial to build a sustained recovery
• the improvements seen so far are extremely sensitive to new developments.

So do we think that the recovery has legs?

There are signs that the sharp deterioration in activity is moderating so we do expect a return to growth over the next twelve months. Indeed, some commentators think that the economy is now at the bottom of the downturn and that we will see a return to growth in the second half of this year.

We think that there are a number of factors that will boost growth over the next few years.

It is important to understand that companies will see the recovery later than investors. They will only really believe in the recovery when they see orders picking up. Some surveys suggest this is starting to happen. However, once they believe that the recovery is sustainable they will raise their capacity, increase their buying of raw materials and the hours worked by their employees, further boosting the recovery. Companies have reduced production too far and the level of stock in the warehouse has fallen sharply. Companies are now raising production levels to build back their stocks to more appropriate levels. This will boost economic growth. (Growth stimulus no. 1:“Rebulding Inventories”).

The pound fell by 25% against our major trading partners’ currencies last year. As orders pick up in the second half of 2009 and next year, exports should rise. British products and services are now extremely competitive in global markets. (Growth stimulus no.2: Exports).

As companies become more confident that the worst of the downturn has passed, employment levels will stabilise, encouraging people to spend more of their disposable income. We expect this to happen in 2010. (Growth stimulus no.3: Modest growth in consumer spending).

However, it’s not all plain sailing. There are a number of headwinds that will constrain growth, particularly over the longer term.

The level of government debt has increased sharply as a result of government stimulus packages and the cyclical downturn. Taxes will rise and public spending will be constrained over the next 5 years. This will limit people’s ability to spend. Investors are also concerned how governments and central banks will unwind their stimulus measures without triggering either a decline in growth, if they respond too early, or a rise in inflation, if they respond too late. This is a difficult policy move to pull off successfully and there is significant scope for the authorities to get it wrong. (Headwind no.1: Higher taxes, government spending cutbacks and “exit policy” error)

The housing market in the UK shows signs of flattening out and new buyers are emerging. However, volumes are modest and, fundamentally, houses are still too expensive for first time buyers to enter the market and underpin valuations. At best, the housing market will be dull with flat prices over a prolonged period. (Headwind no.2: A weak housing market)

There is some evidence that Banks are starting to lend but only to top quality customers and in a very modest way. Bank balance sheets need to contract further and most importantly, residential and commercial property prices need to stabilise in order that the banks can be comfortable with the outlook for bad debts and their level of provisioning. Bad debts tend to peak some time after the recovery takes hold. (Headwind no. 3: Bank lending activity.)

One final point to note: equity markets climb “a wall of worry”. When things look terrible, investors are cautious, share prices are extremely depressed and bargains abound. Even though markets have bounced sharply over the last few months, most investors remain cautious. Even the more positive ones believe that the headwinds will constrain the upside. If investors’ worries don’t materialise, share prices will rise as investors gain confidence in the outlook. Investing in bad times often pays off.

Overall, whilst there may be some short term setbacks and unless there is a major unexpected shock to the financial system, we believe that the green shoots should blossom into recovery.

As to the speed and extent of the recovery... well, that’s what we’re looking at now. We think there is a good chance that recovery could surprise on the upside but that growth over the longer term will be constrained by the headwinds we mentioned above. The Governor of the Bank of England, Mervyn King, believes that the economic outlook is unusually difficult to assess at the moment so we’ll keep watching for any changes in the environment ready to position the portfolios to benefit from how we expect the future to unfold.

If you have any questions on this article please email us on responsibleshareholding@cfs.coop

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April 2009 Investment Commentary – As safe as houses?

I’m not sure where the phrase ‘as safe as houses’ came from. I presume it was a comment on the sturdiness of a house in the face of turbulent weather or difficult times. In recent years it has also developed investment connotations. As the property boom expanded houses were seen as a very safe, indeed profitable, place to invest your savings. Many individuals and investors saw a significant increase in their wealth due to property ownership, which encouraged further investments to be made.

Regardless of where the phrase came from, it is becoming increasingly clear that it is in need of a re-write. Depending on which survey you look at, UK house prices have fallen approximately 18% in the last 12 months. This is a fall of truly historic proportions. How much further have house prices to fall and what are the investment implications of this?

The valuing of houses is as much an art as a science. Most judgements are made on a relative basis i.e. the house down the road sold at price x and this house has a bigger garden therefore is worth 10% more. There is good reason for this. It is difficult to value a house on an absolute basis. Anyone with buildings insurance will note that the re-build cost of a house is always significantly less than its value. Although some of this difference will be down to the cost of land the house is built on, even with that included there is likely to be a significant difference. Rental value is another measure that can be used. How much rent can a property collect over its life time, and what is the value of that? Again this rarely accounts for the entire value of a property.

So what other factors are at work? Well, crucially, the value of a property is significantly influenced by the willingness of banks to lend money against it and the price they are willing to lend at. This is because most buyers of property will require a mortgage therefore the size and affordability of that mortgage relative to an individuals earnings is a critical determinant of house prices. The cost of mortgages goes up, house prices go down. Loan size to value of property goes down (they were as high as 100% in the property boom) house prices go down. This is exactly what is occurring currently.

Finally, property is also a form of investment and is subject to speculators, who have no intention of living in the property themselves, coming into the market buying property on the expectation that it will increase in value over the coming years. The UK property market has been rife with speculation over the last decade as prices continued on a perceived upwards only trajectory.

Using the above, we have now a framework to consider the future path of house prices:

1. 1. New build costs
2. 2. Land values
3. 3. Rental value
4. 4. Mortgage availability and cost
5. 5. Property speculators

What is clear from a cursory glance is that all these indicators are unambiguously deteriorating, suggesting further falls in house prices are very likely. By far the most important factor in the view of The Co-operative Asset Management is point 4. The banking crisis is causing a significant reduction in the amount banks are willing to lend and an increase in the cost of this lending. This is driving house prices down rapidly and gives a strong clue as why it is critical that the banking system be repaired and repaired fast. The sooner this is done the smaller the fall in future house prices. Currently the stock market is expecting further falls of 15-20% in house prices but these expectations will rise or fall depending on how quickly UK banks begin lending again. Further falls of this size are certainly not out of the question.

Investment Outlook

The future path of house prices is of critical important to the UK and global economy. Housing is where this economic and financial crisis began (too much lending by banks at too low prices resulting in a property boom and now bust) and where it will end. Stabilisation in house prices would result in fewer bad debts for banks, would support consumer expenditure and be a key milestone in placing the global economy on a more stable footing. This is why the Governments around the world are being aggressive in pumping taxpayers money into the banking system as it recognises this is the only way to encourage bank lending and therefore support the economy. Up until now this has had limited success but there is little doubt that should current measures not work further Government intervention will occur.

March was a better month for equity investors. Recent initiatives both in the UK and around the world suggest Governments are at last recognising the scale of the problem we face and are acting accordingly. A stabilisation in house prices and therefore the overall economy would be taken extremely well by the stock market, potentially causing further upward moves in equity prices. How likely is this? That is the $64,000 question and that The Co-operative Asset Management is currently focussing on. One thing we are confident of though is that house price moves will be a critical determining factor of future stock market moves and as such merit very close attention.

If you'd like to provide feedback on this article, please direct it to responsibleshareholding@cfs.coop

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