– An article by Samuel Harrison (MIF 09.2011) –  

Whilst there can be no doubt that the present level of public debt across the globe is unsustainable, some would contend that the current state of affairs has been brewing for some time now. Indeed, S&P were actually arguing this as early as 2006. They reported that steadily ageing populations would cause most OECD countries to lose their investment grade status by 2040, as a result of deteriorating economic prospects and the expenses associated with caring for an elderly population. With anemic GDP growth unanimous across developed countries, the investment community is further leaning on emerging markets to add some shine to the desolate macro environment. 

Should the desperate state of government finances be the main area of focus for equity investors? Perhaps not. Even in lieu of the solid market recovery we saw in October, opportunity is still abound. Whilst escalating public debt remains a headwind and is certainly worrisome, that should not detract from the fact that many corporates are still in a stronger position today than they have ever been before. Balance sheets are robust, as leaner companies continue to observe benefits in place of the excess fat they trimmed during the great recession.  Indeed, the somewhat tepid recovery since 2009 has had little bearing on the broader macro, especially with investor confidence in central banks and governments at all-time lows. Most analysts agree that the recovery has been earnings led, with companies exceeding expectations time and time again, pushing up stock prices. These continuous earning surprises have been virtually the only reason for optimism in recent years, whilst the macro has done little but deteriorate. Fortunately, this trend seems to be continuing through the 3Q11 earnings season, with the majority of companies reporting solid results. In particular, integrated energy names posted broadly strong results, including BP.L, BG.L, TOTF.PA, ENI.MI. Financials have been somewhat less encouraging, with mixed BAC results and exceptionally poor GS figures making global headlines. UK banks began reporting this week, which should make for interesting reading. Barclay’s bank was the first to report today and is leading the way with solid and well-rounded results.  

Overall, yes, governments need to cut a considerable amount of public spending and as a last resort, also hike taxes to get back into shape (Note: the former is easier to execute and altogether more likely to be effective). Unemployment also remains stubbornly high. Both of these issues create a definite headwind, which investors should bear in mind. However, if companies continue to report good figures both on the bottom and also particularly the top line, then my confidence will remain in the markets as will my belief that there is value to be found at today’s levels.  

Management guidance has thus far been neutral for 4Q11, according to BoA-ML. Perhaps then, CEO’s are maintaining a philosophy of under promising and over-delivering. Only time will tell. For now, particularly in the Eurozone, it may be prudent to tread carefully with regards to the easy to tax industries such as tobacco/beverages, as further tightening could be imminent. 

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