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Veritas: Are global markets out of the woods?

Global equity markets enjoyed a strong first quarter in 2012. Many individual markets posted their best first quarter in a decade or more. Evidencing the breadth of this strong performance the MSCI World returned 11.5 per cent in the quarter. The difference from December could not be more marked. Investors are back in risk taking mood and this is particularly evident in the returns generated in equity markets.

It seems two major “causes” have led to this volte face in sentiment by investors between December and March:

•       The actions of the ECB through its Long-Term Refinancing Operation in which the ECB offered unlimited quantities of cheap money for three years to Euro area banks (with the requisite “collateral”). This amounted to over one trillion euros in two tranches.

•        The modest improvement in economic data emanating from the US.

The LTRO has had a beneficial impact by ensuring Euro area banks had plentiful access to liquidity (thereby pushing any liquidity issues into the future) which consequently had an extremely positive impact on investor sentiment. However, given the subsequent rise in risk assets (especially equities) a note of caution is now warranted. While not taking the same form as the quantitative easing undertaken by the Federal Reserve in 2008/9 and 2010 the impact of such large scale money printing by the ECB has been in many ways akin to QE.

In December there were rumours that European banks could not fund themselves and some of the peripheral European countries were unable to economically fund themselves. The LTRO has helped both of these issues (at least temporarily). However, staving off the bankruptcy of some European banks and sovereign nations is not the same as creating solutions to the underlying problems which still persist. The understandable sigh of relief in equity markets has morphed into a misplaced optimism that the underlying problems facing a number of European countries and their respective banks have been solved. This is not the case as the patient still suffers from the disease despite the alleviation of the symptoms.

Excess liquidity provision is an extremely blunt policy tool with unintended consequences. The LTRO has (temporarily) tackled some specific issues related to the liquidity of some Euro area banks but it has also had an abnormally large impact on the sentiment of market participants. Risk off has quickly been replaced by risk on and the fear of missing out on the next leg up in markets.

Our view is that the global economy is not out of the woods yet. Debt levels remain abnormally high and can only persist with equally abnormally low interest rates. In the event of sustained inflation central banks would be faced with a difficult choice: raise rates and create a recession or let inflation take hold. Furthermore Euro-land is facing dire problems, constrained by a monetary union that does not suit all its participants equally. The US is in better shape but is still in the emergency room with zero interest rates and fiscal deficits as far as the eye can see supporting the modest growth that is being generated. Simultaneously the world’s growth engine, China, is slowing down. Whether this slow down can be crafted into a “soft landing” remains to be seen.

Based on the valuations of the companies that we analyse, equity markets seem modestly overvalued at March 31, Even allowing for a more positive outturn than our conservative figures suggest, equity markets do not appear cheap. However, with the uncertainties that exist today (many of which have binary outcomes) perhaps equity markets should be demonstrably cheap to compensate?

Andy Headley is global focus fund manager at Veritas

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