Business Profile
By Duncan Graham
Blink and one might have missed the brief, four-session, period of weakness from the UK equity market, the FTSE 100 Index having previously joined European equities in posting the strongest two month rally since…1975.
Make no mistake, we have never believed that equity markets go up in a straight line and given what remains a very difficult operating backdrop, confirmed on Thursday, May 21 news that credit rating agency S&P had downgraded its outlook for the UK, periods of circumspection (and shorting activity) are likely to punctuate the equity market revival over the remainder of the year.
That being said, we remain bullish. Our long-held end-2009 4900 FTSE 100 target was once regarded with what might best be described as doubt and at worst open ridicule. Yet 4900 it remains and at the time of writing the “blue chip” index is, once again, around 10 per cent shy of that target level. What should investors be making of the rally thus far? Is it time to reassess? Is it time to be a little more discriminating going forward?
Cyclical sectors have outperformed their defensive counterparts over a period which actually started in late 2008, but really only began to manifest itself obviously once professional investors started to ‘pair trade’, selling defensives and covering short positions in cyclicals and particularly financials. However, given the still dire nature of the macro economic backdrop we suspect that the bulk of the market’s revival has been both indiscriminate and pretty low quality. By this we mean that all cyclical and financial shares have benefitted, not just those we regard as being the best. News that the World Bank has raised its outlook for global growth going forward has helped trigger the short covering which many attribute the latest equity market revival to be.
In essence, the issue relating to high or low quality boils down to the strength of a company’s balance sheet and its ability to generate free cash. The indiscriminate nature of the recent equity market revival is clearly evident in the extent to which highly financially geared companies have outperformed their more lowly geared counterparts. Analysis points out, in somewhat uncanny fashion, that this period of relative outperformance actually began on March 9; the very day global equity markets began their turbo-charged ascent from the abyss.
While more controversially, as we accept that there are a number of very high quality and well managed companies in the mid and small cap company universe, the recovery period has been marked by significant relative outperformance from the smaller end of the market and, more globally, a period of strong relative outperformance from emerging markets. This over a time which has also been characterised by a period of dollar weakness, itself often a function of rising global investor risk appetite.
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