By MARCEL PORCHERON 31/07/2008
Whilst the MSCI World index is down 10.2% in sterling terms over the last six months, this statistic hides an increasingly wide divergence in the performance of underlying sectors and companies. This presents a new challenge for fund managers who had benefited from a generally rising tide until recently.
Market trends
The disparity between best and worst performing sectors globally has been rising and a 39% performance differential separated MSCI World Energy from MSCI World Diversified Financials sector at the end of June. Only two of the mainstream sectors, materials and energy, produced a positive return over the last six months whilst all the others produced negative performance. Traditionally defensive sectors like utilities and healthcare held up relatively well, but still fell 4% and 9% respectively. That was the good news!
Source:Lipper
Global slowdown
Underlying the poor performance of global equity markets is tightening global credit and slowing global growth. The more difficult operating environment is having an impact on many companies who are reporting a deceleration in profit growth or losses, even the higher growth emerging markets have not been immune to this trend.
The diversified financials sector, which includes brokers, insurers, asset managers, banks and real estate companies, was the worst performer, down 30% over the last six months. Since its peak in June 2007, this sector has now declined 42%. A raft of other sectors also underperformed the broader market. These include anything exposed to consumers like retailers, autos, consumer durables and media.
Earnings revisions turn negative
Stock markets are a discounting mechanism for the future and so changes in the expectations for future earnings can also help to explain declines in equity markets. This change in expectations can be measured using revisions to earnings forecasts made by analysts and a snap shot for these are shown in the bar chart below.
By revising their earnings expectations analysts are either increasing or decreasing their earnings forecasts for the underlying companies in the index. This measure can be useful as a guide to how bullish or bearish the analyst community is. Typically analyst forecasts trail the curve in that they tend to underestimate the strength of change in corporate earnings in a growth environment and underestimate their weakness in more difficult conditions, but the general direction can be useful in explaining the performance of markets: forecasts were generally too optimistic except in the resource sectors.
Since June downward revisions to earnings forecasts have actually increased. Earnings expectations are now weak across all major regions and most sectors. Overall earnings expectations are strongest in the resource and software sectors and weakest in financials. Russia and Hong Kong are among the few major markets to have seen improving expectations.
Where next for stock markets?
The large divergences between sector performances that have become apparent indicate that we are in a more difficult environment for managing money. In recent years equity markets rose strongly and many less able fund managers benefited from generally rising stock prices. In future it’s likely to be more important than ever for fund managers to be invested in the right stocks and sectors if they are to outperform the market.
On this basis, managers with a strong track record of stock selection and sector allocation can really benefit and Nigel Thomas, who runs Axa Framlington’s UK Select Opportunities Fund, is one of the best.
Managers who have the fund management tools to protect their portfolios and the ability to use them can also benefit in this environment. Both Tim Russell at Cazenove and Mark Lyttleton at Blackrock run absolute return equity funds which use hedge fund style portfolio management techniques to produce absolute returns for investors.