Shares digital

What can investors do to protect themselves from the current economic gloom? Russ Mould considers some strategies to make the best of a difficult time

Last week’s three central bank meetings may have seen the Bank of England, US Federal Reserve and European Central Bank (ECB) leave their key interest rates unchanged, but the lack of movement inspired markets. The Dow Jones Industrials surged 332 points, or 2.9%, when the Fed held rates at 2% last Tuesday (4 August). The FTSE 100 and FTSE Eurotop 300 held gains made on the back of that rally when the Bank of England and European Central Bank (ECB) left rates at 5% and 4.25% respectively two days later

Such enthusiasm for no action reflected relief rates were not increased. That rate rises were even considered an option by the market may seem odder still given the credit crunch and the grinding impact the lower availability and rising cost of debt is having on Western economies.

Yet soaring food and oil prices have presented central bankers and equity markets with a dilemma in 2008: whether to confront inflation and economic overheating or recession and an economic slowdown as the bigger problem. A third scenario – stagflation, as economic growth falters but prices rise sharply – is the worst of all, as it would take equity investors back to the 1970s, when equities performed appallingly.

Uncertainty over the fate of the globe’s major economies has hamstrung equity markets in the developed world (see figure 1). Shares believes recession is ultimately the biggest threat but, to help investors fathom the economic data, bankers’ doublespeak and economists’ confusion, we have assessed all three scenarios – recession, inflation and stagflation – picking a total of ten ways to defeat any gloomy scenario that could develop.

Recession

It requires little detective work to find data supporting the view the UK is sliding toward a major economic slowdown – assuming it is not in one already – as the global credit crunch moves into its later stages. So what are the four stages of the crunch?

Stage 1: Losses on exotic debt securities and property lending

Multi-billion dollar losses at two Bear Stearns hedge funds last July were the start of banking markets’ woes. According to data published in the Financial Times (FT) the world’s banks have suffered $476 billion of losses on their holdings of asset-backed securities (ABS) since last July. A year after its first hits, Merrill Lynch revealed additional losses of $5.7 billion on its collateralised debt obligations (CDOs) in July, when the stricken bank also raised $15.2 billion by selling some CDOs at knock-down prices and tapping the equity market yet again. Further losses at other banks are likely since the value of the ABS holdings is tied to that of US housing – where May’s Case Shiller survey showed an average price decline of 15.8% in the 20 cities monitored, the worst figure since the survey began in 2000.

Stage 2: Non-property related losses and corporate failures

These debt losses mean banks have become more reluctant to lend so as to protect their balance sheets from further damage. According to the Financial Services Authority (FSA) net lending by UK banks has declined by 28% between Q3 2007 and Q1 2008 to £73 billion. Corporates have therefore found it harder and more expensive to refinance the debt with which many of them fund day-to-day business. The Insolvency Service revealed a 15% year-on-year jump in British firms going into insolvency in Q2 2008 and HBOS (HBOS) and Lloyds TSB (LLOY) noted a rise in corporate bad debts in their recent results statements. The International Monetary Fund (IMF) now expects UK GDP growth of just 1.4% in 2008 and 1.1% in 2009, against official Treasury forecasts of 2.0% and 2.5%.

Stage 3: Broader economic slowdown

Profit warnings from airlines such as British Airways (BAY) and easyJet (EZY) have shown how private and business travellers are cutting back. Retail groups such as JJB Sports (JJB) and Marks & Spencer (MKS) have issued profit warnings while supermarket chains Tesco (TSCO) and Sainsbury (SBRY) have seen share prices marked down amid fears consumers are ‘trading down’ to save on cost. Eating out has become more of a luxury. Shares in Clapham House Group (CPH:AIM), owner of the Gourmet Burger Kitchen Chain, have collapsed from 340p to 96p in the past year. Luxury brands such as yachting equipment expert Raymarine (RAY), Danish consumer electronics leader Bang & Olufsen, Italian jeweller Bulgari and German car maker Porsche have issued thumping profit alerts.

Stage 4: Defaults on consumer finance packages

Ford and BMW have each issued profit warnings in the past six weeks. Both cited weak demand for their vehicles and write-downs on the lease deals and consumer financing packages they have offered to stimulate demand. BMW took a ?700 million hit and more such woes are likely as the residual value of leased cars falls faster in a weak consumer environment; recent data show UK second-hand car prices fell 14% year-on-year in June. So big banks face write-downs on car and other financing businesses as well as property exposure. According to research from brokers Morgan Stanley, Lloyds TSB has a 20% share of the UK car finance market, with total lease and hire purchase exposure of £10 billion – 2% of its loan book but 50% of its core equity. Total asset finance at HBOS represents 50% of corporate loans, or £6 billion – a mere 0.5% of its loan book but 30% of core equity, according to the broker.

As stage four of the credit crunch takes hold we may expect further retrenchment by cash-strapped banks. The follow on of the lending drought, seen most acutely so far in the housing and construction markets, all points to rising unemployment. House builders Barratt (BDEV), Bovis (BVS) Persimmon (PSON) and Redrow (RDW) have cut 20% to 40% of their staff. Travis Perkins (TPK), Tanfield (TAN:AIM) and Wolseley (WOS) have also announced redundancies: little wonder June saw the biggest monthly jump in UK unemployment – 5,500 – for 16 years.

Inflation

McDonald’s decision this month to add 4,000 UK staff as consumers trade down to cheaper eating options has provided a rare bit of good news. The threat of rising unemployment could hardly come at a worse time for British consumers, who also face higher mortgage costs, fuel bills and grocery bills. The higher cost of debt is one problem but inflation bites into incomes and stunts real wage growth. FSA data reveals house repossessions jumped 41% year-on-year in Q1 2008 and more than 300,000 households are now in arrears on mortgage payments – 2.4% of outstanding loans.

Even after the recent commodity price correction, consumers face a real squeeze. The price of crude oil is still 28% higher than it was in January, while white sugar, corn and soybeans are 23%, 21% and 9% higher respectively. The lagged effect of such price hikes is still biting hard. July saw utility EDF, which owns what used to be known as SEEBoard, London Energy and SWEB, raise electricity prices by 17% and gas prices 22%. Centrica (CNA), which supplies gas to around half of UK homes, quickly followed up price rises of 35% for gas and 9% for electricity.

This must squeeze UK consumers. June retail sales plunged by 3.9% month-on-month according to the Office for National Statistics (ONS), which now believes 2008 will see the first annual drop in UK

consumer spending since 1991 and the depths of the last UK recession.

Other forces are at work. Fear of economic overheating and inflation have thumped far-flung investor darlings, including the Icelandic and Vietnamese stock markets. The prospect of interest rate rises, designed to cool growth now to head off further trouble later, has also taken the shine of GDP growth forecasts and equities in the BRIC quartet of Brazil, Russia, India and China, as Shares (07 August) revealed last week.

India and China have been a source of cheap labour over the past decade and so have exported disinflation. But inflation in India reached a 12-year high of 11.9% in July and prices rose 7.1% in China, so they are now exporting inflation. Higher interest rates and controls on banking reserves have been introduced to cool these economies but overheating

here is not the only imbalance to knock the global economy off kilter.

In its own desperate attempt to stave off recession, the US has slashed interest rates from 5.25% to 2% over the past year, offered a $100 billion tax rebate to consumers and shovelled billions more into its banking system. Unintentionally this has flooded the world with cheap dollars when its other economies, already awash with oil-related cash, did not need extra liquidity.

‘What we have in the US is a classic current account deficit response: permitting the dollar to fall and other assets to fall in price, such as housing and equities,’ Ian Harnett of independent strategy firm Absolute Strategy Research presciently told Shares last spring. ‘Through the dollar currency pegs [in Asia and the Middle East] this exports inflation, just as happened in the early 1970s, when the US was trying to pay for another war, this time in Vietnam.’

Stagflation

This eerily parallels the 1970s, as does the 1973-74 oil price spike, when crude all but quadrupled in price to $12. In a third parallel, a survey from GfK NOP shows UK consumer confidence in July hit its lowest level since records began in 1974.

This seems most appropriate, given the pincer movement of sliding economic growth and rising inflation, which has boxed in Mervyn King and his central banking colleagues. The UK last saw such a combination, known as stagflation, in 1974, when a period of rapid economic growth, fuelled by wild credit expansion, also ended in disaster, not just for consumers, but also equity investors.

Nick Stevenson of equity strategy think-tank Mirabaud Securities explains: ‘Massive flows of speculative cash found their way into supposedly inflation-beating assets as the [UK] economy blazed away toward the fastest real GDP growth rate seen in the past 50 years, at 7.1%. Speculators got rich: their nominal equity and house prices really did outpace rapidly rising inflation.

‘But the late-1973 oil crisis and subsequent stagflation, made worse by a miners’ strike and extensive power shortages, took the UK equity market’s price/earnings (PE) multiple down into single digits, where it stubbornly remained until 1985. Over the period from the 1972 peak to the end of 1982, UK investors lost 56% in real terms,’ Stevenson adds.

It may feel like ancient history, but the parallels are hard to deny. Few if any market participants then are here to tell the tale now, even if clear lessons can be learned from this period. Luckily, Shares’ John Marshall was working at the time for stockbrokers Joseph Sebag and his experiences give vital pointers (see The 1970s Remembered).

Mirabaud’s Nick Stevenson and his data crunchers also offer valuable conclusions on how investors best weathered the 1970s ‘perfect storm’ of inflation and dismal economic growth. ‘The collapse of growth – but stubborn persistence of inflation – after September 1973 turned several crack-up boom winners into hefty stagflation losers,’ he says. Stevenson asserts General Financials, Banks and Real Estate fell out of fashion – as they have done in 2007/08 – while Oil & Gas Producers, Tobacco and Support Services stocks did well.

He concludes: ‘The entire period is notable for the persistence of structural trends: UK automotive, chemical, engineering, general industrial and media companies were consistently dreadful; UK food and drug retailers, pharmaceuticals, aerospace, electronics and various consumer staples sectors were consistent outperformers over the troubled years from 1969-1982’.

Conclusion, not confusion

Last week’s decisions from the world’s three leading central banks to leave interest rates unchanged suggest the situation remains delicately poised. Over the last 12 months the US and UK have cut rates but the ECB has increased them, so even they cannot agree on what is the appropriate course of action.

A study of two-year treasury yields in the key markets of Germany, Japan, the UK and US also reveals the confusion that has reigned in the bond markets this year. Yields collapsed in Q1 as the market priced in a recession, only to rise again as the oil price and commodity prices rose and inflation was seen as the key danger. Since the ECB’s shock interest rate rise on 3 July, yields have begun to retreat again, as profit warnings from global economic barometers such as car makers Daimler and Ford have again shaken investor faith in growth forecasts (See figure 4).

Ultimately, Shares sees inflation, and implicitly stagflation, as lesser worries for three reasons.

First, high prices will ultimately help cure the inflation they cause, as consumers and businesses are forced to cut consumption. This ‘demand destruction’ tamed the oil, and other commodity prices after prior surges, albeit at the cost of a recession: oil price spikes in 1973-74, 1979-80 and 1990-91 ushered in economic downturns. That the price of oil, copper and other commodities has already started to soften suggests ‘demand destruction’ is here, even though bulls of the economy continue to proclaim all is well.

Second, the redundancy threat should help check salary rises, and help restrain inflation, as workers decide they would rather keep their jobs than price themselves out of them.

Finally, the base for comparison for inflation also eases once winter arrives, as crops, metals and oil prices had began to soar by last Christmas.

Inflation should thus start to peak later this year, leaving central banks to try and tackle the key threat: a recession, as banks tighten credit availability and debt-clogged consumers finally retrench to repair their battered balance sheets.

But to help investors tackle all eventualities, Shares has sifted through the lessons of the 1970s, 1980s and 1990s to pick out a trio of investments to hold back any of the three key threats of inflation, recession and stagflation, and one bomb-proof way of facing up to any doomsday scenario.

THE 1970s REMEMBERED

During the 1973-75 ‘stagflationary’ bear market, Shares’ John Marshall was working as a stockbroker at Joseph Sebag. Here he recalls what caused – and cured – the market’s woes.

Although it is tempting to compare the problems of the mid-1970s with those of today there are many differences. Inflation, which reached over 20% in 1975, is now much less. Industrial relations, which were then at a post-war low, are now much better and businesses are free to manage their own affairs, which they were not then. The real similarity lies in the inability of bankers to realise excessive property loans can bring down a bank, as they did to secondary banks then and did to Northern Rock last year. Do bankers never learn? One final point investors should note is the market bottomed just when all seemed its blackest after the bankruptcy of Burmah Oil. Such a final accident may, perversely, be needed to draw a line under this bear market.

The British economy was in a parlous state, even before the 1973 Yom Kippur war prompted a sudden surge in the oil price. The ill-fated ‘Barber boom’, named after chancellor of the exchequer Tony Barber, had created massive inflationary pressures, which prime minister Edward Heath’s government tried to douse with a mixture of price, wage and dividend controls. These bore down so effectively prices and dividends corporate profit margins were squeezed and balance sheets had to bear an increased investment in working capital.

Industrial unrest, spearheaded by a series of public sector strikes, further hurt the economy. Arthur Scargill’s miners and Derek ‘Red Robbo’ Robinson’s car workers finally prevailed when Heath was ejected from office in March 1974. He fought a general election on the theme ‘who governs Britain?’. ‘Not you mate’ was the response of the electorate.

A new Labour government, under Harold Wilson, stoked the stock market’s worst fears. Tony Benn was made secretary of state for industry and Michael Foot minister of labour, with a brief to appease the already powerful unions.

The economic situation deteriorated throughout 1974, hampered by a thoroughly misguided prices and incomes policy – wages were increased every month while prices could be increased only quarterly. Politically sensitive goods such as beer and bread were frequently referred to the Price Commission. Interest rates were increased in a vain attempt to eradicate inflation. By the end of the year the then benchmark FT30 index market has fallen by more than 50%.

Then came the secondary banking crisis as bankers, giddy with the Barber boom, piled into the commercial property market. They lent unwisely and went belly up in droves during 1974-75, in a lesson a new generation of bankers has yet to heed.

Stock market trading volumes declined massively in 1974. Even a small sell order could knock a share price dramatically. One of my colleagues became a salesman at the beginning of July but did not book his first order until the middle of December.

On New Year’s Eve 1974 the market suffered a further shock when Burmah, which had been regarded as a haven, went bust. Yet within days a prolonged bull market had started. In the dark days of December 1974 senior investment managers met at the Prudential (PPM) and decided the market was cheap. They agreed to start buying in the New Year.

Sentiment turned on a sixpence, helped by changes in the political scene. After a referendum on the Common Market (EU) Wilson shunted Benn and his cohorts aside and in 1975 Denis Healey, as chancellor, introduced a supplementary budget designed to benefit industry and render the prices and incomes policy more even-handed. Companies were able to use rights issues to significantly increase dividend payouts

Healey’s budget provided the basis of economic recovery but the biggest boost for the market came in October 1976, when the government had to go cap in hand to the IMF, which forced a reduction in public expenditure and a cut in borrowings; and James Callaghan, perhaps influenced by his son-in-law Peter Jay, ultimately proved a better prime minister than his predecessor, the more economically literate Wilson.

THREE TO BEAT INFLATION

Randgold Resources (RRS) £24.53 BUY

Market cap £1,869 million

2009 PE 35.7

2009 Yield 0.4%

The metals producer is highly leveraged to the gold price. It obtains spot selling prices for the entire output at Morila and 82% of planned production on Loulo, its two mines in Mali. It has not escaped the industry-wide pressure of rising costs. However, it still managed to report a fortnight ago that half-year pre-tax profit had doubled to $52.3 million on higher selling prices and greater production. The Tongon project in Cote d’Ivoire is under development and should become its third operating mine. Exploration success in Senegal also points towards further additions to its gold reserves.

Tullow Oil (TLW) 734p BUY

Market cap £5,286 million

2009 PE 28.1

2009 Yield 0.9%

High-impact exploration programmes in Uganda and Ghana mean the Irish firm offers strong leverage into any sustained and inflationary rise in the oil price. A plan of one well drilling a month for the next two years will give the share price a healthy lift should any one project prove successful. Uganda should see plenty of action in the group’s acreage in the Albertine Basin, while in Ghana Tullow hopes to follow up on February’s Odum-1 discovery, with a further two wells targeting up to 1.25 billion barrels of oil.

ETFS Silver (SLVR) $20.2 BUY

Net Asset Value per share: $20.1

Silver is known as the poor man’s gold, and the precious metal’s price tends to track that of its lustrous peer, so it also looks a good hedge against inflation. A good way of playing silver is through ETF Securities’ ETFS Silver (SLVR), which was launched in September 2006 and trades on the London Stock Exchange (LSE). In return for a 0.49% management fee the exchange-traded fund tracks the price of silver futures traded on the Commercial Exchange in New York (COMEX). A further bonus is the vehicle is priced in dollars, which would supplement gains in the likely event of further weakness in sterling.

THREE TO BEAT RECESSION

British American Tobacco (BATS) £18.45 BUY

Market cap £36,900 million

2009 PE 13.8

2009 Yield 4.7%

Demand for cigarettes is unlikely to flag markedly even during a recession, and BAT’s strong exposure to emerging markets should mean any cutbacks by western smokers should have minimal impact on its profits. Consensus earnings growth forecasts of 13% for 2008 and 12% in 2009 would stand out in a recessionary environment and if attained BAT would enjoy a considerable re-rating. Factory rationalisation and an emphasis on four global drive brands – Dunhill, Kent, Lucky Strike and Pall Mall – underpin growth assumptions. A 4.4% yield is also attractive.

Capita (CPI) 713.5p BUY

Market cap £4,395 million

2009 PE 18.9

2009 Yield 2.3%

Shares in the business process outsourcing group spent the first six months of this year going nowhere fast but their defensive qualities have come to the fore in July and August in the form of a 15% bounce. There should be more to come. A long-term earnings growth record of 25% compound EPS growth over the past ten years is so good it cannot be down to luck, but rather good execution and shrewd strategic positioning. A fat backlog of long-term projects gives credence to earnings growth forecasts of 22% for 2008 and 15% in 2009.

National Grid (NG.) 674p BUY

Market cap £16,565 million

2009 PE 11.5

2009 Yield 5.8%

A 22% price plunge in National Grid’s share price this year looks unmerited and a clear buying opportunity, especially as it leaves the £16.7 billion cap on a prospective yield of 5.8%. The owner of the UK’s electricity transmission network has to be one of the safest plays in a recessionary environment, particularly as the group has plans to sell off non-core businesses and focus on its core business in the UK and US. A 25% leap in earnings per share last year is forecast to be followed by rises of 14% and 8% for fiscal 2009 and 2010 respectively and healthy hikes in the dividend payout are on the cards too.

THREE TO BEAT STAGFLATION

AstraZeneca (AZN) £25.39 BUY

Market cap £36,902 million

2009 PE 10.2

2009 Yield 4.5%

Fears over litigation, generic competition and weak product pipelines have seen AstraZeneca suffer a four-year de-rating but a PE of 10.2 and 4.5% yield now discount a huge amount of bad news for a leading stock in a sector that traditionally outperforms in times of economic crisis. Chief executive David Brennan believes acquisitions, deals to extend the life of existing drugs and a $2 billion cost-cutting programme will reinvigorate the firm, and if forecasts of 22% EPS growth in 2008 and 9% in 2009 prove accurate it is hard to see how AstraZeneca’s shares cannot continue their recent revival.

QinetiQ (QQ.) 199.5p BUY

Market cap £1,318 million

2009 PE 12.2

2009 Yield 2.6%

Defence stocks outperformed in the mid-1970s when stagflation ruled, and QinetiQ is a good play on a repeat of this, not least as a strategic repositioning of the group means it is due a rerating. The £1.3 billion cap may have initially proved a dud after 2006’s float at 200p but a robust growth strategy has begun to pay off. The key US operation has gained critical mass and IT services orders have begun to flood in on both sides of the Atlantic. A £5.7 billion order backlog is a good basis for any stock and it is unlikely governments will stop spending on the war against terrorism, whatever the economic conditions.

ETFS Gold (BULL) $12.3 BUY

Net Asset Value per share: $12.2

Gold generated huge gains when it trebled in the stagflationary crises of 1973-74 and 1980-82. It even soared in the Great Depression of the 1930s when it became the ultimate haven for battered investors. A direct play on gold is therefore a must for any portfolio designed to beat the renewed risk of stagflation and ETF Securities’ ETFS Gold is just that. In return for a 0.49% annual management fee the exchange-traded fund, launched in September 2006 and traded on the LSE, tracks the DJ-AIG Gold Sub-Index and pays a

capitalised interest return that accumulates daily.

ONE TO BEAT ALL EVENTUALITIES

db x-trackers FTSE 100 reverse ETF (XUKS) £11.07

The FTSE 100 is already down 18% from its 6,732 June peak. This matches the decline seen in 1990, caused by an oil price spike and recession, but is mild compared with the 71% stagflation fall of 1973-74 and the 51% tech bubble drop of 2001-2003 . This may seem unduly bearish but each of the 1973-74, 1990 and 2001-2003 bear markets climaxed with a final 20% to 25% capitulation sell-off in the final three months. A hedge against such a climactic lurch down is this reverse ETF, which rises in value as the FTSE 100 falls: if the index drops 10%, the product rises 10%.