Fund Manager
Frank Mersch
The third quarter of this year exhibited many of the classic symptoms of an aging bull market with earnings growth beginning to fade, economic imbalances taking centre stage, and a surge in asset price volatility into crisis territory. While economic historians struggled in their efforts to figure out which past event the most recent crisis resembled (the currency crisis of 1997, the crash of 1987, the mid-cycle slowdown of the mid 1990s, etc.), it became clear that the US Sub-prime Mortgage predicament would have both far-reaching and material consequences. By mid-August the worry in the capital markets was at its peak, with major mortgage lenders teetering on the edge of bankruptcy (Countrywide Financial) and marquis investment funds admitting that they would be taking write-downs in their funds due to their exposure to Sub-prime mortgage-backed debt instruments. Investors responded by liquidating significant portions of their portfolios and pushingprices down across seemingly all asset classes. Most tellingly, money market and overnight lending rates shot higher as short-term credit markets seized up and access to liquidity became paramount.
The central banks of the world (namely the European Central Bank) responded by pumping billions of dollars of liquidity into financial markets and talk quickly turned to the need for interest rate cuts in order to avoid a pending economic catastrophe. While the ECB had talked itself into a corner regarding the course of interest rates, the US Federal Reserve retained the option to begin easing rates, and did so to the tune of fifty basis points in September. With core inflation rates sliding over the first half of the year (from 2.8% in February to 2.1% in August), clearly the Fed had the opportunity and the political astuteness to take decisive action and reassure markets. Equity markets rallied sharply after the rate cut, more than making up for the 6.5% dip between the end of June and mid-August. Although subsequent economic data have proven to be fairly resilient (stronger than expected retail sales, moderate employment growth, a better trade balance), investors have not yet lost their new -found risk aversion. Moreover, with credit spreads widening sharply (although still low by historical standards), the brisk merger and acquisition activity that had characterized the equity markets for the past year fell rather sharply. As a result, equities will trade more in line with their fundamentals than with lofty take-out values.
At risk of repeating ourselves, despite the largely US-specific credit concerns, the global growth story appears to be still intact. In fact, Chinese GDP growth in the second quarter increased at the fastest pace in twelve years, coming in at 11.9%, while inflation ticked up to a two year high at 4.4%. As we have said in the past, the Chinese growth story has visibility through at least this year (the national Congress year) and next (Beijing Olympics) and this has been reflected in the stable (yet still historically high) prices for commodities. While we would expect yet higher interest rates in China (and likely other emerging economies) over the next year, it seems likely that the increasingly consumer-oriented Chinese growth machine will continue.
Over the course of the past few months we have maintained far larger than normal cash levels in the portfolio, ranging between 25% and 40%. Given that we believe the global growth story is still largely intact and that the US will muddle through without sliding into recession, we are largely positive on equity markets and would expect them to trend higher into the end of the year.
Frank Mersch - Q3 2007 Commentary
Date Published
Fund Manager
The third quarter of this year exhibited many of the classic symptoms of an aging bull market with earnings growth beginning to fade, economic imbalances taking centre stage, and a surge in asset price volatility into crisis territory. While economic historians struggled in their efforts to figure out which past event the most recent crisis resembled (the currency crisis of 1997, the crash of 1987, the mid-cycle slowdown of the mid 1990s, etc.), it became clear that the US Sub-prime Mortgage predicament would have both far-reaching and material consequences. By mid-August the worry in the capital markets was at its peak, with major mortgage lenders teetering on the edge of bankruptcy (Countrywide Financial) and marquis investment funds admitting that they would be taking write-downs in their funds due to their exposure to Sub-prime mortgage-backed debt instruments. Investors responded by liquidating significant portions of their portfolios and pushingprices down across seemingly all asset classes. Most tellingly, money market and overnight lending rates shot higher as short-term credit markets seized up and access to liquidity became paramount.
The central banks of the world (namely the European Central Bank) responded by pumping billions of dollars of liquidity into financial markets and talk quickly turned to the need for interest rate cuts in order to avoid a pending economic catastrophe. While the ECB had talked itself into a corner regarding the course of interest rates, the US Federal Reserve retained the option to begin easing rates, and did so to the tune of fifty basis points in September. With core inflation rates sliding over the first half of the year (from 2.8% in February to 2.1% in August), clearly the Fed had the opportunity and the political astuteness to take decisive action and reassure markets. Equity markets rallied sharply after the rate cut, more than making up for the 6.5% dip between the end of June and mid-August. Although subsequent economic data have proven to be fairly resilient (stronger than expected retail sales, moderate employment growth, a better trade balance), investors have not yet lost their new -found risk aversion. Moreover, with credit spreads widening sharply (although still low by historical standards), the brisk merger and acquisition activity that had characterized the equity markets for the past year fell rather sharply. As a result, equities will trade more in line with their fundamentals than with lofty take-out values.
At risk of repeating ourselves, despite the largely US-specific credit concerns, the global growth story appears to be still intact. In fact, Chinese GDP growth in the second quarter increased at the fastest pace in twelve years, coming in at 11.9%, while inflation ticked up to a two year high at 4.4%. As we have said in the past, the Chinese growth story has visibility through at least this year (the national Congress year) and next (Beijing Olympics) and this has been reflected in the stable (yet still historically high) prices for commodities. While we would expect yet higher interest rates in China (and likely other emerging economies) over the next year, it seems likely that the increasingly consumer-oriented Chinese growth machine will continue.
Over the course of the past few months we have maintained far larger than normal cash levels in the portfolio, ranging between 25% and 40%. Given that we believe the global growth story is still largely intact and that the US will muddle through without sliding into recession, we are largely positive on equity markets and would expect them to trend higher into the end of the year.