In fear of subprime contagion

The R word has reared its ugly head recently. It hit the headlines at the end of February when former US Federal Reserve Chairman Alan Greenspan said there was a possibility of a US recession by the end of 2007. “When you get this far away from a recession, invariably forces build up for the next recession,” said Mr Greenspan. “For example, in the US, profit margins have begun to stabilise, which is an early sign we are in the latter stages of a cycle. By the end of the year, there is a possibility, but not a probability, of the US moving into a recession.” Stock markets reacted badly to these comments, along with concern that China was to impose a new tax on capital gains and growing concern about the speed of the economic slow down in the US. In the week to 2 March, the Dow Jones Industrial Average fell 4.2 per cent and the S&P 500 dropped 4.4 per cent. These were the largest weekly falls for four years. It meant February was the first negative month for both indices in nine months. There has been a lot of publicity about foreclosures at the subprime end of the mortgage market. Subprime mortgages are taken out by borrowers with poor or limited credit records and typically charge interest rates of 2-3 per cent above conventional mortgages. There are concerns these problems could spread to the rest of the housing market and hit consumer spending. In February, fourth quarter 2006 US GDP growth was revised downwards from 3.5 per cent to 2.2 per cent. S&P 500 earnings rose by under 10 per cent for the first time in 13 quarters in the fourth quarter of 2006. Furthermore, consensus analyst forecasts for 2007 earnings have fallen to around 8 per cent. Subprime infection Diane Jaffee, manager of the SGAM Fund Equity US Relative Value fund, says her portfolio has not been directly exposed to the subprime property market but she is not as concerned as some economists about the threat of its problems spreading to the rest of the mortgage market. “We have positions in [US home loans provider and guarantor] Fannie Mae because the capital position is so strong,” says Ms Jaffee. “Its US regulatory oversight body stipulated Fannie Mae has a minimum 30 per cent capital surplus, which positions the company well in today’s volatile environment.” When deciding whether to invest in companies, Ms Jaffee says they must meet at least one of three fundamental catalysts. These are cost cutting and restructuring, new products and markets and new management. Companies must also meet three of five valuation measures. Ms Jaffee says Fannie Mae meets two of the company-specific fundamental catalysts. These are cost cutting and restructuring and new management after the problems of the past few years. “We are optimistic about the Fanny Mae companies after the restructuring they have already been through.” She has recently added Citigroup to the fund. “Citigroup’s share price has suffered a 7 per cent fall this year but it has undergone fundamental changes. It has sold its asset management business to Legg Mason and recruited a new chief financial officer from American Express, who has significant experience with the credit card business and restructuring companies. Therefore, with new management and restructuring, Citigroup meets two of our three company-specific catalysts.” Other recent additions to the fund are Legg Mason and consumer electronics company, Circuit City. The fund is over-weight in telecoms stocks. Holdings include AT&T and Qwest. Ms Jaffee points to the fact that over two years, Qwest’s cash flow increased from $430m (e316.2m) to $1.4bn in 2006. Ms Jaffee is sanguine about the outlook for the US economy despite fears of a hard landing. She argues that while a growth rate of 2-3 per cent may be below trend it is not “even close to recession parameters”. Mark Hammond, an analyst on the Fidelity Funds America fund, says it takes a bottom-up-growth-at-reasonable-price approach to stock selection. The fund uses traditional measures to evaluate valuation, says Mr Hammond, including price/earnings ratios and the return on equity. He says manager Katherine Collins was cautious about valuations before the correction at the end of February. Mr Hammond says: “The market had risen since July 2006, in an almost straight line. At the same time, earnings forecasts had come down in January and February from double digit growth to 7-8 per cent. The correction was probably more to do with concerns about a US economic slowdown than events in China.”

‘Surveys suggest 80-90 per cent of fund managers expect the US to enjoy a soft landing. We were getting concerned about complacency among fund managers’ - Mark Hammond, Fidelity Funds

Part of the reason why Ms Collins was becoming cautious was because of the growing consensus about prospects for a soft landing for the US economy. Mr Hammond continues: “Surveys suggested 80-90 per cent of fund managers expected the US to enjoy a soft landing. We were getting concerned about complacency among fund managers.” Ms Collins is finding investment opportunities among US equities, says Mr Hammond. These include rating agencies, the shares of which were hit by the subprime problems. But Mr Hammond says there is no legal recourse to rating agencies. Shopping around Other stocks in which the fund has invested are Johnson and Johnson and Wal-Mart. He says: “We believe Wal-Mart is a misunderstood stock and is mispriced by the market. Most analysts are based in the north east of the US but the stores vary considerably around the country and the company is having success outside the north east.” Bob Doll, manager of the Merrill LIIF US FlexEq fund, says the question is no longer whether the US economy is slowing but whether the slowdown will represent a transition from a few years of above-trend growth to a period of more sustainable but slower growth or does it indicate that a recession is coming. He points to the problems in the housing market, slowing manufacturing activity, declining retail sales and some evidence of a weakening labour market. Mr Doll, who is also chief investment strategist at Blackrock/Merrill, does not believe problems in the subprime lending business will trigger an economic recession. “Despite all the problems in the housing sector, consumer spending levels have remained reasonably strong, corporate balance sheets are still in good shape and non-US economies, particularly developing economies, also are quite strong. “We believe these positive factors will outweigh the negatives and the US economy will avoid a recession, although a growth scare could still rattle the financial markets.” Mr Doll is optimistic about the outlook for equities. “Although we recognise a number of risks remain and we retain our view that short-term market action is likely to remain choppy, we do not believe the bull market we have been experiencing since late-2002 is set to end any time soon.” Mary Chris Gay, manager of the Legg Mason Value fund, however, says the evidence of the past few months has been mixed on whether the US economy is weakening or strengthening. Recession looms She adds a number of factors have provided renewed concerns that the risks to the economic outlook may be more weighted to the downside. These include the downward revision to GDP growth from 3.5 per cent to 2.2 per cent. Expectations for corporate profit growth have moderated. Consensus earnings per share growth for the S&P 500 index has fallen from 9 per cent early in 2007 to just under 8 per cent. Another concern comes from the turmoil in the subprime mortgage market. “While the full implications are not yet clear, the situation is getting pretty ugly,” says Ms Chris Gay. “Spreads on subprime loans have widened dramatically this year and a number of subprime lenders’ stocks have collapsed. Concerns about these subprime lenders have broadened to include larger mortgage lenders as well as the major money centre and investment banks, most of which have large mortgage operations and many of which have extended lines of credit to subprime lenders.” Despite such concerns, Ms Chris Gay believes the S&P 500 and other major market indices will deliver positive returns this year. “A market correction was long overdue and is healthy,” says Ms Chris Gay. “The market was stretched on the upside and the sell-off is acting to relieve that condition.

‘Positive factors outweigh the negatives and the US economy will avoid a recession, although a growth scare could still rattle financial markets’ - Bob Doll, Merrill Lynch

“Our bullish stance on the market continues to be based on expectations of moderate earnings growth plus dividends and some degree of P/E multiple expansion. “Although consensus earnings growth expectations for the S&P 500 have declined in recent weeks, they remain within the range of our more subdued expectations. We believe the S&P 500 index is worth 17 times 2007 earnings but trades at less than 15 times those figures.” Furthermore, says Ms Chris Gay, the sell-off has improved investor sentiment measures. The spike in volatility is also a good sign, she says, as it normally coincides with “intermediate-term market bottoms or attractive buying points”. Gregg Powers, co-manager of the Nordea 1 American Value fund, says that of the 54 stocks in the portfolio, a third are in the cyclical consumer goods sector. He says alongside media companies, they are primarily casino and hotel operators. “A company like MGM Mirage, the largest single stock at around 10 per cent of the fund’s volume, has in recent years evolved from being a pure casino operator to all-round leisure group,” says Mr Powers. “As casino and gaming stocks extend their gains, we remain positive about the outlook for our investments in the industry. Growth of gaming in the US and internationally continues to fuel opportunities for these businesses.” Technology fillip The Nordea 1 American Value fund has a relatively concentrated portfolio, with the top 10 holdings accounting for 60 per cent of the fund. A third of the fund comprises stocks from the technology sector. “A global investment cycle in hardware/software and ongoing consolidation could be good news for performance in 2007.” Mr Powers is optimistic for the rest of 2007. “We do not predict a recession in the US. In conversations with senior officers of the companies in which we are invested, this is also the consensus view. US stocks are not expensive relative to other asset classes right now. “The fact we are fully invested as value investors proves we can find enough cheap, attractive companies in the US. We are optimistic about the situation for companies in the portfolio and that should also be mirrored in their share performance going forward.” The Legg Mason Value fund famously failed to outperform the S&P 500 in 2006 after beating the index for the previous 14 years. Few fund managers manage to outperform the market consistently. This is partly attributed to the fact the US stock market is efficient and many US equity funds take a strong style bias, such as deep value, value or growth. Ms Jaffee says 2006 was the eighth consecutive year in which her fund has out-performed the S&P 500 index. She admits, however, the fund has been assisted by the value bias in the market over some of this period. “We are relative value managers. We can invest in companies as long as they have one of five valuation characteristics that either is equal to or less than the average of the S&P 500 index or in the case of dividend yield is equal to or greater. “This provides a larger universe than that available to deep value managers. For example, in 1999, the market had a P/E of 33 on the next 12 months’ earnings and we were able to invest in companies with P/Es of 20 to 25. This means we participate to a greater degree than deep value managers when growth is in favour.” She says the fund suffered on a relative basis in 2006 because of the spread between the Russell 1000 Value and Russell 1000 Growth indices. The spread reached 13 percentage points in favour of value. Even in 2002, the spread only reached 11 per cent. This favoured deep value managers, says Ms Jaffee, more than relative value funds. The performance of the Fidelity Funds America fund has been affected over the past year by a change in the market environment, says Mr Hammond. “Performance of the fund was hit during the correction in May and June 2006 and the summer as there was a significant change in market behaviour. “The market had just woken up to rises in interest rates and the oil price approaching $70 a barrel. This led to concerns about the pace of economic growth. It also prompted relatively better share price performance by the mega caps. “The fund was underweight in larger companies although not as much as some other funds. But since later in the summer, relative performance has picked up. Therefore, if performance is maintained, the one-year numbers will start improving. Most of the under-performance came from the correction in 2006.”