Transcript 2002 outlook - mid year review FFG Global Investment Research

2002 outlook - mid year review
FFG Global Investment Research
July 2002
FORUM FINANCE GROUP S.A
Investment Perspectives 2002 - Mid Year Review
2002 mid year review
A look back
FFG
A first quarter recovery…
At the beginning of this year we felt that the US economy would likely enjoy a
substantial rebound in the first quarter of this year, as companies moved to replenish
their inventory levels after a full year of decreases. Our enthusiasm was however
tempered by the knowledge that the resulting production would have to be consumed
by strong end demand to maintain growth levels for the remainder of the year. In
essence, the consumer would have to remain strong at least until the summer months
when increased business spending would take us through the rest of the year. Our
premise was that capex would not take hold until late Q3/Q4, as companies continued
to reduce expectations in the face of the most dramatic inventory correction in history.
Supported by consumption through the summer...
As expected production boomed in Q1 and as hoped the consumer held fast until the
end of the first quarter. GDP was up strongly and most indicators pointed towards a
continuing recovery. To this point the consumer (supported by growing confidence in
the recovery) was stable, as cash rebates, home equity loans and mortgage refinancing
put substantial supplies of money back into his pockets. In addition, 0% interest loans
on autos and white goods fueled an onslaught of durable goods purchases (pulling
much of the next cycle’s sales into the fading recovery) which gave hope that the
consumer was still feeling wealthy.
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Stifled by Enronitis…
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Unfortunately while the consumer did stage a comeback in the first quarter, serious
concerns surrounding corporate governance would arise. In response to the Enron
debacle, investors began to question the integrity of nearly every corporate balance
sheet. The result was a slow yet steady decline in equity values, as well as widening
credit spreads, which threatened companies relying on commercial paper to finance
their working capital.
Growing corruption scandals coupled with numerous
bankruptcies led to a complete lack of confidence in corporate management, the
financial system and equities in general.
And the greatest bear market since the 1930’s...
By the end of July, stock markets had seen declines of 20-30% over 6 weeks and the
bear market had surpassed in both depth and duration of that of the 1970’s. It had
become the greatest post depression bear market in history. The consumer appeared to
give in as confidence indicators fell significantly, thus increasing the evidence of a
potential double dip, and completing what appeared to be a self fulfilling prophecy.
Copyright Forum Finance Group S.A.
July 2002
FORUM FINANCE GROUP S.A
Investment Perspectives 2002 - Mid Year Review
2002 mid year review
The Economy
FFG
Base for recovery set...
While the protracted bear market and economic slowdown has prompted companies and
individuals alike to par down their outlook, it has also caused them to streamline their
operations. Companies have significantly reduced staff (unemployment has risen to nearly
6% from a peak of 3.9%) cut expenses and reduced inventories (the largest ever reduction in
inventory value in the history of the US economy) in an effort to cope with the realities of a
new lower level of growth.
This indicates that although things could get worse, the economy has already seen
significant restructuring. In essence the base is set for the return of growth to the economy
and continued productivity growth (1.1% in July after 8.6% in June) attests to the fact that
there remains leverage to the upside in the economy.
However consumer may be running out of gas…
Our initial 2002 outlook postulated that the consumer would be the linchpin to the entire
economic recovery. As the driving force to the remarkable resilience of the US economy,
continued consumer spending would be required to bridge the gap to the return of business
investment. Refinancing is becoming marginal, tax rebates have been spent, and the record
level of auto sales appears to be declining. In addition the continued barrage of corruption
scandals and market declines has taken its toll, as consumer confidence has reversed its
upward trend and retail sales have started to slow.
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It looks as though the consumer will further reduce spending in the near term and will be
unable to bridge the capital spending gap so crucial to avoiding a second slowdown in the
US economy. While through most of the 1990’s saw retail sales hover between 5 and 10%
annual growth, we have declined to around 2% presently. Credit growth, along with what
appears to be the consumer’s attempt to rationalize his balance sheet has fallen and
purchases of durable goods - very closely linked to New home construction have begun to
show weakness.
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Corporate profits falter and balance sheets lack flexibility to resume spending …
While corporate profits rose strongly in the fourth quarter of 2001, government statistics
covering all companies and industries shows that growth has slowed and profits declined
slightly in Q1 2002. More importantly, while Capex declines appear to have bottomed, year
over year changes remain negative and with Capacity utilisation at historically low levels
the odds of a pick up in Capex this year are becoming more remote.
As a result of the catastrophic situation in the equity markets and the corporate governance
crisis in the US, company sources of funding has been virtually shut down. Equity is out of
the question, the commercial paper markets are open to only the very largest companies
(and only just) credit spreads have become prohibitive to those issuing bonds and bank
credit facilities have become increasingly rare.
Copyright Forum Finance Group S.A.
July 2002
FORUM FINANCE GROUP S.A
Investment Perspectives 2002 - Mid Year Review
FFG
While our outlook was for improving capex trends it did not include such a decimated
financing landscape. Given the negative capex outlook of many companies in the latest
quarter, we believe that business investment will not begin to recover until early 2003
and not late 2002 as we previously had estimated.
Making a period of slow to negative GDP growth even more likely…
The consumer will begin to reign in spending with durable goods, autos and home
improvements, a reduction which by our estimates could take retail sales down by as
much as 1%. With the declining propensity to spend on leisure items and services, we
estimate that growth in consumption could slow to 1-1.5% over the coming quarters.
With no growth in Capex, we estimate that GDP growth could stall to below 1%
annualized, something that most economists have not yet accounted for.
Completing the recession with a consumer led final yet muted decline …
The capitulation of the consumer will give this recessionary cycle a classic tone, and
allow for a recovery to be based upon what will likely be pent up demand. And while
slow GDP growth is not to be taken lightly, we do believe that given the current low
levels of consumption and with corporate America positioned for slowing growth the
impact over the longer term might not be severe. Levels of inventories remain low and
unemployment has leveled off, while productivity gains continue. This leads us to
believe that the slowdown will be short lived (2 quarters maximum) and that growth
should resume by the end of Q1 2003. We estimate that GDP for the year will come in
around 2%, thus a significant slowdown in the 2nd half can be expected.
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Followed by a consumer led bounce in early 2003 …
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The consumer will begin to resume spending by early next year, as stable incomes,
increased savings and nine months of belt tightening give the consumer incentive to buy even though some demand has already been eaten up in the consumption of autos, white
goods and home improvements (and new home purchases). As both consumer and
corporate America will have “stretched” their purchase cycles by this time, the need to
replace computers, clothing and electronics will be there. With a strengthening consumer
as support, capital expenditures in industry will recover. 2003 should provide better
prospects, near the 3.5% mark as capex expands, but still far from the 9% growth
witnessed in late 1999.
Copyright Forum Finance Group S.A.
July 2002
FORUM FINANCE GROUP S.A
Investment Perspectives 2002 - Mid Year Review
Markets
A certain slowdown probably priced in…
FFG
With many global indices down between 20-35% this year and in the final phase of a 2
year bear market, it would appear that the markets have been telling us that something was
not right with the economy and that slower growth was probably around the corner. As
revisions to growth estimates continue to come in from economists around the globe, and
consumer sentiment indices attest to the weakening condition of the consumer, the market
has adjusted itself violently to the newly developing consensus - a slow recovery.
As valuation looks reasonable...
The recent correction has brought many markets more in line with historical levels of
valuation, as the S&P 500 recently touched a forward PE of 15, in line with similar
recessionary exists. This valuation is even more reasonable given current levels of long
term interest rates hovering around 4.2%. Our dividend discount model based on theses
parameters and a slightly increased risk premium puts the market at a 15% discount to
current levels.
And while expectations are probably still too optimistic...
Unfortunately the models are based upon operating earnings and not final earnings.
Furthermore, they are built around expectations for earnings which may not yet be
reasonable. We believe that going forward there are a number of issues that must be dealt
with to bring expectations back in line with reality. Analysts have been increasing their
estimates for 2003 and have only begun to take into account the slowdown in 2nd half
2002. Moreover, technology earnings expectations remain stretched and while the outlook
has stabilized it is not clear that strong growth is right around the corner.
And volatility remains very high...
With markets on extremely oversold technical levels, each day brings with it severe levels
of volatility. The lack of clear conviction in the markets, coupled with extreme swings
caused by the ever increasing presence of hedge funds in the market place make the
coming months challenging.
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Markets should provide solace by the beginning of Q4…
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Habitually the markets have acted as prescient indicators of the economic future. It is
likely that this case is no different. We believe that most of the decline is in the price now,
and that the coming months will continue to be volatile. There is a risk of continued
decline, however we think that this does not exceed an additional 10-15% to the downside.
More importantly, we believe that by Q4 the market will begin to discount a consumer and
business led recovery in 2003.
In such an environment, we will find value at severely oversold companies with solid
financials and quality management. Given the muted outlook for equities, we think
prudence is the watchword, but that increased allocations to certain companies and sectors
is warranted. We would use market weakness to increase our holdings in the healthcare
sector, select technology companies, and consumer stocks .
Copyright Forum Finance Group S.A.
July 2002
FORUM FINANCE GROUP S.A
Investment Perspectives 2002 - Mid Year Review
Risks
FFG
The risk of a more severe downturn…
The current economic situation on the face of it remains moderately positive compared to
recessions past and to the oft-cited Japanese economy. Many indicators, while recently
showing weakness, have remained remarkably strong throughout the downturn especially
in the consumer sector. However the economy in the US and in Europe remains
vulnerable to a number of threats.
Should the housing market weaken substantially…
There is a possibility that as part of a final breakdown in the economy, the consumer sector
begins to fade. While in itself not too alarming (giving the already low base from which
we currently operate), it may be severe enough to spark a drop in real estate pricing. The
average price of homes over the past year continues to rise as second quarter data shows
that average homes in North America rose almost 8% in the second quarter compared to
last year (with coastal and large metro areas showing gains as high as 15%).
Surging home values have enabled many homeowners to tap into the equity of their homes
to spend it on goods and services, which may become a concern as average earnings fall
and households earn less in a stalled recovery. We have noted that the household
affordability index has begun to show some weakness, and while still high it may be the
harbinger of bad news on the horizon. In an environment of falling home prices, consumer
sentiment is hard hit, and prices can fall significantly in very short periods of time - putting
a severe squeeze on many who may have counted on the recovery to maintain a bull
market lifestyle.
Global Investment Research
Or dis-inflation turns to deflation...
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The decade of the 90’s (and much of the 80’s) was essentially a period of declining interest
rates and inflation. Globalization in the economy allowed companies to reduce the cost of
labour and production by moving into developing countries. Technology allowed even
greater productivity gains for companies both in administration, sales and production.
Proof lies in the capacity (though questionable at some technology firms) of the aggregate
economy to continue to reduce inventory levels as a function of sales.
However, these gains in general have been offset by price declines invited by the increased
competition that globalization brings with it. With little pricing power companies have
been hard pressed to turn these developments then into hard profits. As the economy slows
and prices adjust downward with demand the dis-inflationary trend accelerates. At a
certain point, dis-inflation becomes deflation, and unless productivity continues to rise
(and past adjustments continue to put its value into question), company’s will become
unable to cope. Ad to this an uncertain dollar and the trend for US companies may be
forced to answer some tough questions should this recovery stall.
Copyright Forum Finance Group S.A.
July 2002