Stay Long Global Equities Versus Bonds

Positive fundamentals indicate that global equities will continue to outpace bonds, albeit less decisively than in the past year.

BCA have published four factors underpin the bull story for stocks. First, the global economy will post solid growth again this year, which points to healthy earnings gains. Second, ongoing globalisation and technological innovation should keep inflation subdued, meaning that central bank policy rates will rise only slowly and long-term interest rates will stay low. By extension, liquidity conditions will remain buoyant, suggesting that a potential re-rating of equities could unfold. Finally, stocks are highly attractive relative to bonds and should continue to attract flows. Bottom line: While global stocks are vulnerable to some near-term turbulence, the cyclical outlook remains positive.

Fed rate decision.  Greenspan steps down.  Bernanke takes the helm

Last night the US Federal Reserve’s FOMC raised the key Fed Fund rate by a further 0.25% to 4.5%. The move represents 350bp tightening in the most intense tightening process in a quarter of a century. The Fed Funds rate stands at its highest level since 2001. The prime lending rate is now 7.5% (i.e. US consumers can no longer be said to be benefiting from cheap credit).

What will the Fed do next?  The accompanying statement was doveish, although it’s more likely that this reflects less about Greenspan’s last FOMC or Ben Bernanke’s first and more what the Fed collectively thinks regarding prospects for the US economy. The statement, which withdrew the word “measured” for the first time in the twenty month rate hiking process, alludes to the fact that core inflation had stayed “relatively low” and that longer term inflation expectations remain “contained”.

However, the statement did refer to “risks weighted mainly towards conditions that may generate heightened inflation pressure in the foreseeable future”.  This is standard practice when the Fed ceases its process of monetary tightening and may not necessarily mean that rates are going yet higher (next meeting March 28th).

Bottom line: Over the past four decades, when the Fed moves to hold (from tightening) for a period of six months or more, all things being equal the next move is always a rate cut!

…. What are the equity market implications

The equity market is likely to react positively to indications that Fed policy is easing; however, greater attention is likely to be paid to incoming Chairman Ben Bernanke. Recent history suggests that the Dow Jones has tended to peak within three months of a new Chairman and slide thereafter (some of our older readers may recall that when Greenspan took the helm on 11th Aug 1987, the Dow peaked at 2,722 on Aug 25th and hit 2018 by Feb 25th 1988, -26%. Paul Volcker assumed control on 6th Aug 1979 with the Dow at 849. It peaked on Oct 5th at 898 before falling to 768 six months later, -10%. Before him William Miller took over on March 8th 1978 with the Dow at 751.  Having peaked at 908 on Sept 11th 1978 it slid 7% to 845 six months later).

The past does not repeat itself exactly and we know, with the benefit of hindsight, that William Miller was trying to restore Fed credibility after the inflationary early 1970s. Volcker had to address double digit inflation while Greenspan had not only to curb the inflating equity market bubble but defend a sliding dollar.  With Fed credibility restored the baton passes to Mr Bernanke.  Global economic expansion looks solid enough, inflation is contained, the dollar hasn’t collapsed and the equity market appears robust enough.  Bottom line: How Mr Bernanke will be tested in his first few months in office may have less to do with the economic backdrop and more to do with his own approach to policy setting.

Lloyds TSB in perspective

Persistent bid speculation is pushing up Lloyds' share price (+27p to 537p as we write).  The speculation is of a bid at 700p (yesterday Times, also Guardian), which is 38% above Wednesday's closing share price.

The valuation of Lloyds at 700p:

• The market capitalisation for Lloyds would be £39bn and as such would be a large deal for any acquirer. It compares with, for example, Spanish BBVA's market capitalisation of $56bn (£38bn) and Wells Fargo at $100bn (£56bn).

• The largest players have consistently gained market share in recent years and therefore potentially the purchase of Scottish Widows will interest other medium-sized players in the UK market, such as either Aegon or Axa.  For the four largest players, the benefits of a deal are less obvious given the low returns made by Scottish Widows and the diminishing benefits of scale. 

• Previous transactions for banks have ranged between 14-16x PE.

• Abbey National was acquired by Santander on 16x but the profitability of Abbey had declined. In contrast, Lloyds' profitability is strong.

• For a bidder, there is an opportunity to build the corporate and wholesale banking activities in the UK, though there appears little opportunity to grow the retail profits. Lloyds management itself is looking to grow the corporate and wholesale business after prior years of underinvestment. 

The book value of Lloyds is estimated at c.180p, of which 45p is goodwill, suggesting total goodwill on acquisition at 700p of c.£32bn.  This makes the acquisition of Lloyds a substantial bite even for the largest bank. For comparison, BBVA has c. £10bn of Tier 1 capital and is currently bidding for BNL. 

Bottom line: While a bid for Lloyds is improbable at this stage, speculation is likely to remain in the share price for the foreseeable future. Valuing the life business on 12x EV earnings and the bank on 10x (in line with domestic banks) yields a value of c.460p. Using that as an estimate of fair value then at 535p, crudely the share price is attaching a 30% probability of a bid at 700p.  

And finally………………….

Bill Gates recently gave a speech at a High School about 11 things they did not and will not  learn in school. He talks about how feel-good, politically correct teachings created a generation of kids with no concept of reality and how this concept set them up for failure in the real world.

Rule 1:  Life is not fair - get used to it!
Rule 2:  The world won't care about your self-esteem. The  world will expect you to accomplish something BEFORE you feel good about  yourself.
Rule 3:  You will NOT make $60,000 a year right out of high school. You won't be a vice-president with a car phone until you earn both.
Rule 4:  If you think your teacher is tough, wait till you get a boss.
Rule 5:  Flipping burgers is not beneath your dignity. Your Grandparents had a different word for burger flipping:  they called it opportunity.
Rule 6:  If you mess up, it's not your parents' fault, so don't whine about your mistakes, learn from them.
Rule 7: Before you were born, your parents weren't as boring as they are now. They got that way from paying your bills, cleaning your clothes and listening to you talk about how cool you thought you were. So before you save the rain forest from the parasites of your parent's generation, try delousing in your own room.
Rule 8:  Your school may have done away with winners and losers, but life HAS NOT. In some schools, they have abolished failing grades and they'll give you as MANY TIMES as you want to get the right answer. This doesn't bear the slightest resemblance to ANYTHING in real life.
Rule 9:  Life is not divided into school terms. You don't get summers off and very few employers are interested in helping you FIND YOURSELF. Do that on your own time.
Rule 10:  Television is NOT real life. In real life people actually have to leave the coffee shop and go to jobs.
Rule 11: Be nice to nerds. Chances are you'll end up working for one!

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.