Wednesday 13 December 2017

You can miss investment opportunities while focusing on gloomy economic data

Philip Lawlor

IT is hard to believe that it is almost exactly a year ago since the eurozone sovereign debt crisis started to erupt. As the situation unfolded over the subsequent months, two significant turning points became apparent.

The first and most significant of these is the seismic shift in the attitude of Germany.

We need to recall that the eurozone was ultimately a political (not economic) construct predicated on German acquiescence and compliance.

Over the last 12 months we have clearly seen the emergence of a much more self-confident, assertive and isolationist Germany.

It is sobering to recall that the German hostility to any notion of bailing out the periphery has occurred when the German economy has been firing on all cylinders with unemployment at a 20-year low.

This poses the obvious question of how Germany will react to eurozone turmoil once their economy loses momentum.

The second key turning point occurred after the initial bail out of Greece when the bond markets realised that the core problem was not one of liquidity but solvency.

Solvency arithmetic states that if a country's nominal GDP growth is lower than the interest on its sovereign debt then the debt-to-GDP ratio will continue to rise.

This is precisely why, despite a succession of austerity measures, peripheral bond yields have continued to soar.

What is apparent is that eurozone politicians have failed to comprehend the elemental power of solvency arithmetic.

There are a few glimmers of hope emerging for the Irish economy. The first is a pragmatic acknowledgement that painful medicine is required. Contrast the reaction of the Irish and the Greeks to public sector pay cuts.

The second is that corporate Ireland is competitive and is delivering a rise in export volumes.

Indeed, Ireland is forecast to deliver a 3pc current account surplus in 2012. Unit Labour Costs (the difference between compensation and productivity) are also being reined in faster than in the other peripheral markets.

Perhaps most importantly the latest bank stress tests and capital injection requirements could mark the nadir in the write down of non-performing loans.

It is worth remembering that all crises have a time line and Ireland could well now be past the half way point.

Over the next couple of years, Ireland will have largely worked through the problem loans. The US Savings and Loan crisis in the early 1990s taught us that markets are very responsive to a turnaround in Non Performing loans.

Looking at the investment environment it is worth noting that the relationship between the performance of the economy and equity markets is not quite what you would expect.

A study by Elroy Dimson of the London Business School showed that between 1972-2009 the countries that had demonstrated the weakest economic growth over the previous five years delivered the strongest subsequent stock market returns.

This illustrates the risk to investors of missing investment opportunities by being too focused on gloomy economic data.

We have seen a clear example of this in Europe over the last few months.

While there was initially strong connectivity between the concerns over sovereign default and the performance of European equities in the first half of 2010 (as the cost of Credit Default Swaps rose the equity market declined). In the second half of 2010 a significant disconnect emerged.

As the Credit Default Swaps continued to rise (reflecting concern over Ireland and broader contagion) the equity market started to rally.

The catalyst for the inflection in equities was the introduction of a second round of quantitative easing in the US. Irish equities were not immune from these positive influences.

In fact it is interesting to note that the Irish General Index (ex Banks) has outperformed the Stoxx 50 index fairly consistently since the beginning of 2010 through to the end of March 2011.

The investment adage 'watch what markets do not what they say' remains apposite.

Philip Lawlor, investment strategist within Smith & Williamson, the investment management and accountancy group

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