Market Bulletin – Bittersweet

A busy week of news for company earnings and economic growth ends with a tumble for technology and tobacco stocks.

It’s true. Chocolates really are getting smaller. Some bags of Maltesers have shrunk by 15%: indeed, 2,529 products have decreased in size in the last five years, while just 614 have got bigger, according to the Office for National Statistics (ONS). The list of shrinking goods also includes fish fingers, fruit juice, beer and toilet roll.

Unusually perhaps, Brexit is not being blamed for this phenomenon. Manufacturers’ costs may be rising because of the recent fall in sterling, but the ONS said it had been observing pack shrinkage long before the EU referendum. Nor has ‘shrinkflation’ been a factor in the general rise in inflation, according to the ONS, although changing pack sizes has apparently contributed 1.22% to the rise in the ‘sugar, jam, syrups, chocolate and confectionery’ index since 2012.

In contrast, the UK economy is getting bigger – albeit only just. The 0.3% rise in GDP in the second quarter, announced on Wednesday, was in line with consensus expectations, but below the Bank of England’s Monetary Policy Committee (MPC) estimate of 0.4%. The figure may be subject to later revision (first-quarter GDP was revised down from 0.3% to 0.2%), but there was general agreement that growth is still too weak to prompt the MPC to raise interest rates.

Growth was driven by retail services, whereas construction and manufacturing exerted downward pressure following two successive quarters of growth. Film production was the second biggest contributor to GDP; the number of people who watched Wonder Woman and the latest in the Pirates of the Caribbean series at the cinema also influenced the results.

The news came after the International Monetary Fund (IMF) downgraded its forecasts for UK and US growth this year, citing “weaker-than-expected” activity in the UK in the first quarter. Although its forecast for UK growth in 2018 was unchanged, the IMF predicted that US growth next year would now be 2.1%, instead of the 2.5% previously forecast. The failure so far of the Trump administration to advance tax reform and infrastructure plans was held as the reason for the downgrade.

Despite that lack of stimulus, the United States Department of Commerce confirmed on Friday that the economy had grown at an annualised rate of 2.6% in the second quarter, compared with a rate of 1.2% in the first three months of the year, boosted by higher consumer spending and business investment. Earlier in the week, dovish comments on inflation by the Federal Reserve heightened speculation that a further rise in interest rates this year may not materialise.

The IMF said that better growth in China, the eurozone and Japan was making up for a slower-than-expected US economy. Christine Lagarde, IMF managing director, pointed to how sources of growth had diversified from the US. Emerging and developing economies now account for 60% of global GDP and 80% of growth.

Tech-tonic

With almost half of S&P 500 companies having reported second-quarter earnings, 73% are beating analysts’ estimates. According to Thomson Reuters, the S&P 500 companies are on course for year-on-year earnings growth of 9.2%.

The world’s three most valuable internet companies – Alphabet (Google’s parent), Amazon and Facebook – were among those to announce earnings. Prior to the results, Amazon’s market capitalisation broke through $500 billion for the first time, joining Microsoft, Apple and Alphabet in the half-trillion-dollar club. But that was short-lived, as the company announced earnings well below market expectations, sparking a steep and sudden sell-off in technology stocks on Thursday.

Market commentators pointed to the remarkable rally in tech stocks this year – Facebook has soared 50% this year – and suggested that the ‘flash crash’ gave little cause for concern in a sector where the earnings picture is currently very different from the dotcom bubble era.

A host of leading UK companies also announced their half-year results. Royal Dutch Shell, Diageo and BAT were among those announcing healthy profits, although tobacco shares plunged on Friday after the U.S. Food and Drug Administration announced plans to cut the amount of nicotine in cigarettes to non-addictive levels, with the goal of preventing thousands of tobacco-related deaths a year.

Lloyds Banking Group reported its biggest half-year profits in eight years, while setting aside another £1 billion for PPI claims.

AstraZeneca announced a further fall in drug sales in the second quarter, and a major setback for its cancer drug trials also hit the company’s share price, which fell 16% in the immediate aftermath of the results announcement.

AstraZeneca is a major position for Neil Woodford, who commented, “The investment case for AstraZeneca is about so much more than this one trial. Across a broad spread of disease areas, the company is developing new ground-breaking therapies which have significant commercial potential. My view remains that very little of what I believe the company will achieve is reflected in today’s share price and even more so after today’s fall.”

Car cartel?

More than 100 European companies announced quarterly earnings last week and investors were looking for the results to reignite the region’s equity markets, which have stuttered in recent months after gaining nearly 10% by mid-May.

Daimler and Peugeot posted record results, and Volkswagen also announced a doubling of profits in the second quarter. The companies all raised expectations for car sales this year. Yet the results came in the same week as news that the European Commission was to launch another cartel probe, looking into allegations that German car manufacturers colluded for years on the use of technology and suppliers. “It is not obvious that the German manufacturers have gone much further than car makers in other countries,” commented Stuart Mitchell of S. W. Mitchell Capital. “In our view, what is more important is the value that should be created as the VW group restructures in ‎the wake of the diesel-gate scandal. Management has set very ambitious mid-term profitability targets. Furthermore, the group is launching more new models than at any time in the past.”

Elsewhere in Europe, last week marked the first time since 2014 that Greece has made a sale of government bonds. The sale raised €3 billion, although half of the five-year bond buyers were owners of existing Greek debt maturing in 2019, who were enticed to swap their holdings by being paid an extra €40 million.

The bond issue was an important ‘toe in the water’ as to how Greece will cope when the bailout payments end and the country has to meet its financial needs from taxation and borrowing from the markets. The hope must be that a return to the sovereign debt market marks a milestone on the road to recovery for its long-suffering people.

The late-week retreat by tech and tobacco stocks put global markets into reverse. The FTSE 100 Index finished the week down 1.13% and the S&P 500 lost 0.11%. The Eurofirst 300 Index closed the week down 0.41% – a three-month low – while the Nikkei 225 dropped 0.7%.

Debt time bomb?

Alex Brazier, the Bank of England’s financial stability director, warned last week that a sharp rise in personal loans could pose a threat to the UK economy. Outstanding car loans, credit card balance transfers and personal loans have increased by 10% over the past year, whereas household incomes have risen by just 1.5%. Labour MP Rachel Reeves, the new chair of the Business, Energy and Industrial Strategy Select Committee, also expressed concern that the debt problems seen in the run-up to the financial crisis are “rearing their heads” again.

UK households owe more than half a trillion pounds on variable rate mortgages and consumer debt, with interest repayments totalling £39.2 billion a year. A rise in interest rates of just 0.5% would cost an extra £3.4 billion in repayments in the first year alone.

Woodford Investment Management and S. W. Mitchell Capital are fund managers for St. James’s Place.

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