Equity investors should think about what lies ahead

Aug 5 2009 by Andrew Miller, The Journal

AFTER a somewhat lacklustre June, global equity markets made good progress in July as investors’ confidence was buoyed by a generally encouraging start to the US second-quarter earnings season.

Meanwhile, second-quarter US GDP was stronger than expected, although downward revisions to the first quarter and full-year 2008 figures prompted a sharp sell-off in stock markets at the end of the month.

The challenge for investors now is to ascertain just how much of the good news is now priced in; Asian equities in particular have enjoyed very strong returns since early March and it is becoming more important to invest selectively within the region. In Europe and the US, many economically-sensitive sectors have enjoyed stellar returns, even though there are still some doubts about the sustainability of the economic recovery. Consumer confidence in particular is an area of concern, given the ongoing rise in unemployment in the UK, US and elsewhere.

On balance, we still have a favourable view on the long-term outlook for equity markets, although we foresee choppier seas over the summer months.

The main reason for this is that the recent market rally has left equity markets trading at close to what we estimate to be fair value, thus leaving the asset class as a whole vulnerable should macroeconomic and/or corporate news fail to meet expectations.

In the longer term, however, we believe that our main strategic themes remain in place: specifically that Asia excluding Japan is likely to be the most dynamic region in terms of its economic performance.

This in turn should mean that any economic upturn is likely to be favourable for commodities, given Asia’s healthy appetite for raw materials.

One way for UK investors to gain access to any improvement in commodities markets globally is via the equity of the large-cap diversified mining groups, and here our favoured names include BHP Billiton and Rio Tinto. As the world’s largest diversified resources company, BHP needs no introduction, but its shares have lagged peers this year as investors have preferred to buy into higher-risk alternatives (such as Vedanta) or restructuring stories (Rio Tinto). We believe that BHP is essentially a high-quality “defensive” within an economically-sensitive sector, due to its good mix of assets, its strong operational track record and an attractive yield. As for Rio, we believe that the firm has finally resolved a number of its key issues, having abandoned the much-criticised tie-up with Chinalco and choosing the rights issue option instead, while a joint venture with BHP in Western Australia should produce significant synergies for both groups.

For investors who want some exposure to commodities markets (specifically oil markets) but who are worried about the dependability of pure commodity-related earnings given a still-fragile global economy, we like oil services firm Wood Group. Much of Wood Group’s revenues are linked to the operating expenditure of oil companies (rather than their capital expenditure), and its contracts are on a “cost plus” basis with large and stable customers – something that could prove invaluable should the economic downturn last longer than markets currently expect. Given this low-risk profile, and the firm’s decent long-term growth prospects, the current valuation looks attractive.

So, assuming a choppier ride over the remainder of the summer, equity investors should think about what lies ahead thereafter; in our view, the economic recovery should be led by Asia, and that in turn should provide a meaningful boost to commodities markets.

Andrew Miller is regional office head at Barclays Wealth