Market View - March 2012

It may be a bull market currently in global equities but is the UK stockmarket fit for purpose?

The question was raised in a recent Buttonwood article in The Economist newspaper and suggests that the stock market supposedly has two objectives, namely to help savers take part in economic growth through linking their investments to business profits and to encourage the efficient allocation of capital. These of course are by their nature longer term goals which should be totally unaffected by daily fluctuations in the stockmarket.

The reality however as revealed by academic and journalist John Kay in an interim report commissioned by the UK government, is that markets and markets participants including the executives who run businesses are increasingly focused upon short term targets. The report appears to suggest that even so called longer term incentive plans for executives and managers are too short term while the focus upon performance measures such as earnings per share or return on equity may be encouraging excessive risk taking.

The Economist article goes on to discuss some of the actions that investors could take to try and change the short termism prevalent in stockmarkets, but explains that the problem is compounded by the fact that the majority of company equity these days is held by institutions such as pensions funds and asset management groups, while increasingly present on shareholder lists are foreign investors and hedge funds whose interests are not necessarily aligned with those of the long term investor. The article continues “in short, the current market structure does not seem fit for purpose, but how to fix it Mr Kay is leaving to his final report due in the summer, although there is clearly no silver bullet”.

The Economist article lists a number of possible measures that may help before concluding “Above all, it would help to remember that the stockmarket serves a wider goal, and is not supposed to be a sophisticated version of the National Lottery!” Wise words indeed!

Meanwhile 2012’s positive start for global equity markets continued to gather momentum during February as the S&P 500 in the US rose more than 4% (and was up 8.59% since January 1st), the FTSE 100 rose 3.34% (5.37% since Jan 1st), the EuroTop 100 climbed 3.19% (6.18% since 1st Jan), the Nikkei 225 in Japan was up 10.46% (15% since Jan 1st) and finally the MSCI Emerging Markets climbed 5.89% (17.19% since the start of the year!). By contrast the JPM Global Bond index fell 1.09% (up slightly 0.17% since the start of the year), although emerging market debt did much better as the JPM EM Bond index climbed 2.95% (4.76% since Jan 1st).

Going forward there remain many headwinds for the new bull market to overcome, including of course the ever present euro zone sovereign debt crisis, continuing concerns about China’s ability to avoid an economic hard landing, and the admission by the UK’s Chancellor that there is no more cash left in the Exchequer, effectively announcing the likelihood of even more austerity! However, by far the biggest “elephant in the bathtub” as one commentator recently put it is the US and its massive funded debt which is equivalent to its GDP (around $15 trillion) while its total unfunded liabilities (when all future healthcare and social security costs etc.) are taken into account ranges anywhere from £55 to $75 trillion.

By common consent there are only three ways for the US to get out of this predicament, namely by growing its way out, excessively cutting costs, or by devaluing the amount of the debt (via inflation). Since realistically the requisite growth (comparable to emerging market type GDP expansion over several years), is fantasy, and the necessary cuts are politically and socially unpalatable, the third option of continuing currency devaluation leading to further (potentially hyper) inflation appears the strategy that the Federal Reserve and Washington government will follow!

Accordingly while looking to take advantage of the current lull in the storm, and exploit this equity bull market for as long as it continues, caution and care must remain the watchwords going forward!