Stockwatch: As risk increases, opportunities arise

With equities are out of favour and the FTSE 100 near a multi-year low, companies analyst Edmond Jackson makes sense of the threats and how investors can exploit them. 

The UK stockmarket is well into a correction, the FTSE 100 index down over 7% this month or 10% since May. There are also enough growth and cyclical stocks down more like 20% as sentiment shifts to lock in gains and protect wealth.  

The Footsie's performance may be surprising because some have assumed that international/US dollar constituents would offset greater domestic risks with Brexit, but I say this shows key drivers are macro – how the credit cycle is rolling over, and the US stockmarket leads others.  

Supposed "value" stocks haven't really offered a defence, although precious metals have rebounded as traders wrack wits for a safe haven – or simply expectations of one.

I think fears of a No Deal Brexit are overdone: the lesson from Greece was EU talks going to the wire, and both sides will back down to agree on an extension to the UK's transition period, however much that irritates Brexiteers.  The Tories haven't the gall to replace Theresa May or risk a repeat of Black Wednesday 1992.  

So, stop worrying about Remoaner propaganda and brace for a rebound in sterling.

Most crucially: the US "Goldilocks" era is ending  

Moderate growth with low inflation is being replaced by a more uncertain prospect: the US economy growing faster than its ability to support that growth without inflation or significant productivity gains. 

The Federal Reserve is well aware of the Trump administration pouring on inflationary fuel – big tax cuts amid a lack of spare capacity, late in the economic cycle -  hence Fed chair Powell's resolve to press on raising interest rates.  The Fed wants to pre-empt inflation and build scope to cut rates for stimulus effect come the next downturn.  

Current rate rises are viewed contentiously though, as trade tensions fester between the US and China, e.g. Caterpillar and Harley-Davidson have warned this last week they will have to raise product prices to offset higher raw material costs after steel import tariffs.  

•    US Q3 2018 earnings season

•    Keep Calm and Carry On?

US stocks are jittery because traders have drunk the Kool-Aid too long.  I noted one investment strategist put in a tall order only recently:

"US companies need to sustain confidence in rates of 20% earnings growth currently being reported, for the next few quarters, also the US and China agree on trade, otherwise sentiment will break."

Yes, there's still an element of buying dips in US stocks, but its vigour is gone hence the line of least resistance looking increasingly downwards.  Hopes are shifting to chart studies: that past performance (my emphasis) shows US stocks rally after midterm elections.

Source: TradingView S&P 500 monthly chart (*)    Past performance is not a guide to future performance

Other negatives have erupted this last month: Italy's budgetary stand-off versus the EU, albeit a known factor; and fears the Chinese economy rests on a mountain of shadow debt, trade issues now prompting an inevitable slowdown.  

The surprise element – if not potential black swan event – has been uproar at Saudi Arabia following Jamal Khashoggi's death, which, if leading to isolation and sanctions, could prompt a furious oil embargo.  Western diplomacy is put in an awkward spot to condemn yet limit mutual damage.

Precious metals are enjoying some rebound

It's a notable development for investors seeking protection, if tricky to read.  Gold has been a favourite shorting candidate for hedge funds, thus heightened global risks may have prompted short-closing and buyers accentuated a price lift.  Silver is even more notoriously volatile, whatever trend usually apparent with hindsight. 

The difficulty - if interest rates are in a rising scenario - is precious metals' lack of yield working against them as a store of value.  What's different this time is equity/bond prices moving downwards together, making it tricky to diversify risk by way of uncorrelated returns.  

Possibly the traditional sense of an inverse relation between equity and bond values will re-establish but as yet it's a dilemma.  Since a lot of liquidity was generated during the QE years, it only needs a modest element to alight on a particular asset class like precious metals, to prompt upturn.  

I'd keep an eye on this sector, both Exchange Traded Funds and selective equities.  For example, Fresnillo and Centamin jumped nearly 10% in a day, possibly accentuated by short closing after two-year falls.

Italian crisis: a general warning about rampant debts

Don't be swayed by warnings it will prompt a market crash and euro break-up.  Polls have shown 60-72% of Italians want to remain in the euro; the issue is politicians exploiting dissatisfaction with the EU to get elected with unrealistic spending plans.  

The lesson of Greece was that politicians' bravado prevails only before the stark prospect of a highly-indebted euro nation actually leaving the bloc – how financial markets will exact a hefty toll on its currency, also penal debt service costs.  So, expect plenty more noise as Italian politicians try to prove to their electorate that they are at least trying to deliver on manifesto promises.

The chief upshot of Italy is a reminder how global debt has soared to record levels following years of monetary stimulus.  

Here, the Bank of England (BoE) has warned about high-risk loans to already over-indebted companies, drawing parallels with the growth of US subprime mortgages in 2006.  Last year the UK saw a record £38 billion leveraged loans issued by "shadow banks", some £30 billion this year, in a £1 trillion equivalent global market led by the US.  

The BoE fears about 80% of such loans are "covenant-lite", hence a contemporary form of sub-prime posing a risk to the UK economy once interest rates rise.  Stress tests due shortly will include the risks of leveraged loans on both bank and non-bank lenders.

More positively, latest research from UK insolvencies specialist Begbies Traynor, show levels of significant financial distress down 1% since Q2 2018, despite a rise of nearly 21,000 on Q3 2017 to 469,006 companies.  

Property also hotels & accommodation fared relatively worse – up 2% - although seemingly cyclical sectors such as construction, retail and printing/packaging saw insolvencies ease 2%.  Mind, this is all a snapshot in time and the BoE rightly points to latent financial risk. 

A trend to exposing the "bezzle" is apparent

Accounting misrepresentation at Patisserie Holdings may look just another AIM scandal, but in big picture terms it supports a trend of dodgy figures that started early this year with support services group Carillion, hit drinks supplier Conviviality, and has just been revealed at AIM-listed energy supplier Yu Group, sending its stock down from about 600p briefly below 100p.  

The economist John Kenneth Galbraith wrote in a time-honoured way, of the "bezzle" which exists at any time to some degree in an economy, and takes various forms - from a costly morass of errors to outright swindles – tending to accumulate during prosperity as corner-cutting increases e.g. to meet high stockmarket expectations.  

"Months or years may elapse between the commission of the crime and its discovery" (witness Patisserie's investigation going back years) "during which there is a net increase in psychic wealth...which varies in size with the business cycle...in good times money is plentiful, people are relaxed and the rate of embezzlement grows...in depression all this is reversed...audits become penetrating and meticulous, commercial morality improves, the bezzle shrinks."

If such examples multiply, they are consistent with business cycle excess, hence liable to portend downturn.

Weaker UK equities encourage US takeovers

Stock-pickers can take heart how "bite-size" well-positioned UK-listed firms remain takeover targets for US business – currently benefiting also from a favourable exchange rate, as US rate rises strengthen the dollar.  

The latest example is Communisis, a small cap customer communications group that saw its stock drop from about 70p below 50p recently, prompting a 71p cash offer valuing the business at £154 million.  

•    Intrigued by this share's potential

•    A takeover with Brexit in mind

I initially drew attention at 40p in January 2016 and last had a 70p target when updating last May, thus shareholders could feel they're being given a reasonable exit as macro uncertainties grow – yet the bidder will get control without any real underlying premium, then exact value by integrating with its existing operations.  

Quite as with recruiter Harvey Nash I've also favoured in past years, you sense it's premature to sell given these firms are poised to capitalise on development initiatives and yet boards seem willing to crystallise value – as if believing share price highs won’t be regained for a good while.

In conclusion: stormy markets look set to continue as a cold front of macro reality hits over-heated equities, especially in the US.  Special situation hunters can for a start, contemplate bid potential and precious metals.

*Horizontal lines on charts represent previous technical support and resistance. Red line represents uptrend since March 2009.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.