Serious Money: The second quarter of 2006 has seen a reversal of fortune for global equity markets, with nearly all the gains achieved in the first quarter being erased.
Commentators have attributed many causes for the correction, ranging from geopolitical unrest (Iran), the subsequent move in oil back over $70 (€55.62) per barrel and inflated commodity prices.
Our view is that the primary cause for concern was fear of a further rise in interest rates leading to bond market weakness, in part triggered by a change at the helm of the Fed.
At the very time that analysts questioned bond markets based on current interest rates, comments from the Fed suggested further upward moves in short-term rates, causing significant bond market weakness, which in turn caused equity market concerns.
What cannot be ignored is that during the second quarter commodity prices sky-rocketed, driven by expectations of never-ending growth in India, China and other emerging economies, but also by the sheer weight of money created by the below-average interest rates created in the aftermath of 9/11.
The result of these two factors created a speculative bubble in commodities with gold, copper, silver and other precious metals hitting all-time or multi-year highs during May.
So where does all the above leave us now and have we changed our outlook for markets?
There are two points to make at this juncture. Firstly, given the fall in commodity prices from their highs, it is clear that a significant amount of the speculative froth has been removed from the market, and the resultant decline in commodity prices is of itself deflationary. The second point to make about the current market volatility is that the underlying fundamentals of the market remain intact.
Our fundamental thesis on equity markets as set out in our January strategy document has not changed and the following points explain why this is the case:
n this is the first significant correction since the March 2003 low;
n the decline has been futures-led, driven primarily by hedge funds;
n it is not an earnings-related decline as corporate profitability continues to remain robust.
While the current market volatility is unwelcome, it does present investors with opportunities to buy quality equities with attractive valuations and yields.
In our April strategy document, we reduced our sector weightings in telecommunications and cars. This reduction has been fully justified as both sectors struggled to perform.
In terms of the banks, the recent pre-results trading updates from the UK and Irish banks have been very positive, supporting our ongoing preference for the sector. Despite the backdrop of rising global interest rates, the level of impairment charges has not deteriorated significantly amongst the retail banks, reflecting the quality of lending.
While margins are under pressure due to the current interest rate environment, the level of margin erosion is in line with market expectations.
Our preference within the sector is for shares with no US exposure, since the inverted US yield curve will put additional pressure on margins. On this basis, Bank of Ireland, HBOS and Lloyds remain our top picks.
The pharmaceutical sector enjoyed something of a re-weighting in the second quarter as strong sales of key drugs and talk of further consolidation within the sector pushed prices higher.
Positive newsflow from the major participants and less emphasis on the FDA helped create a more positive environment for stocks within the sector than was the case in the first quarter. Also helping the sector was its traditional defensive qualities, which came to the fore as the volatility in equity markets increased towards the end of the quarter. While product pipeline is still of concern to the market, recent positive news flow has helped alleviate some of these concerns. GlaxoSmithKline continues to be our top pick.
The basic attractions of the oil sector remain, with strong cashflows funding share buyback programmes and increasing dividends.
While reserve replacement is an issue for the sector (particularly Royal Dutch Shell) the cost of production is significantly lower than the current level of crude oil.
Also in the sector, there are a number of smaller independent producers such as Sterling Energy who benefit significantly from the higher oil and gas prices. BP and Sterling Energy are our current top picks in the sector.
The construction sector is one of the few sectors that has been successful in passing on the cost of higher energy and raw materials.
The sector has suffered in recent weeks as the current phase of global fiscal tightening has heightened concerns over global growth and raised doubts over earnings growth. While there is no doubt that the operating environment has become more difficult in recent months, the geographical spread of operations of the leading companies in the sector to some extent eases the pressure on earnings.
For instance, the UK housing market has seen prices pick up, while some areas of continental Europe, eg Holland, are also showing signs of a pick-up. Domestically, the commencement of the SSIA maturity will be positive for the DIY sector, particularly Grafton Group. Overall our top sector pick remains CRH, which currently trades at a 10 per cent discount to its peers.
The media sector meanwhile had a difficult year as advertising revenues in both the printed and the visual spaces remain depressed.
The failure of Daily Mail and General Trust to sell its regional titles highlighted the difficulties facing the print media sector, while it seems not even a month of World Cup football will boost already weak advertising revenues for ITV.
BskyB has overcome the restructured Premier League match allocation, however its monopoly on the rights have been weakened considerably. Reuters failed to boost revenues by as much as the market would like, while the volatile financial markets will not be helpful for sales. WPP offers investors the best option in a difficult sector, as it benefits from World Cup related advertising.
So to sum up, our top 12 stock picks for 2006 are as follows: 1. Adidas; 2. Aviva; 3. Bank of Ireland; 4. British Land; 5. BHP Billiton; 6. Grafton; 7. GlaxoSmithKline; 8. Independent News & Media; 9. Kerry Group; 10. Ryanair; 11. Sterling Energy; 12. Vodafone.
Stuart Draper is head of research at Dolmen Securities.
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