Stockwatch: Deflation fears return yet opportunities beckon

August heralds an ironic twist. The US Federal Reserve's latest statement painted a relatively bright picture of the world's second largest economy, i.e. continuing to prepare people for a rise in interest rates. Yet commodities are in the throes of another sell-off, as if signalling something deep about a lack of demand. While a 15% fall in oil prices over a month, probably reflect the easing of sanctions on Iran and rising US shale oil output, other economic indicators give cause for concern.

Asian trade performance has slowed again after a post-crisis rebound in 2010-2011 to about 7%, compared with 30% pre-2008. Lower activity is intertwined with weaker demand, the broad reason why first-half 2015 earnings at Chinese companies are expected to be lower and the third quarter no better. Who knows if the drop in the Chinese stockmarket might have some wider effect, despite it resulting from excess margin trading. The strong dollar is a chief reason why more US firms are not meeting expectations. These two largest economies are a reminder how the global situation is pretty fragile, with investors challenged as to what asset classes offer genuine protection. 

Between the devil and the deep blue sea

Is the deflation monster stirring just as central banks have talked themselves into raising interest rates? Individual members of the US and UK central banks occasionally spout their opinions, if averaging towards a consensus that it is wise not to delay a rise much longer. Years of monetary stimulus mean markets are likely overvalued and could react even more adversely if the business cycle is turning down. But their dilemma is that any rate rise risks revenge by the "debt genie" as borrowers are caught between higher debt service costs and reduction in their ability to service it. 

A stark example is Tullow Oil which has de-rated from the FTSE 100 to Mid 250 index, a price fall from £16/share to about 240p lately: its interim results show net debt of £2.3 billion against gross profit halved to £220 million, hence net losses after the interest rate hit. Essentially Tullow is out-of-synch with the times, its borrowings suited to when oil prices were nearly twice current levels. It faces the debtors' dilemma whether to restructure promptly - i.e. issue shares - before self-reinforcing negatives drive their price lower, hence cost of equity higher. Plenty of other companies have increased borrowings e.g. in support of share buybacks, adding to downside risk if underlying performance deteriorates.

Not to be pessimistic, just underline the risk how equities are exposed to central banks' resolve to raise rates, precisely when various deflationary forces may be combining to hurt business performance. The recent plunge in the NASDAQ-listed shares of Apple was partly due to concerns over new products, also the general problem of a rising dollar undermining export sales for big US firms. That's linked to developing countries' demand, which could soon be impacted further by higher service costs of their dollar debts. Apple is high-profile for this issue, yet it applies widely.

Mixed company reporting, albeit bid prospects

For the first time in a long while I sense a sea change, if lacking any real trend in warnings that reflect economic pain beyond the resources sector (and its support firms).  Recruiters - often a tell-tale for medium-term prospects - continue bullish updates, although mind these tend to be weighted towards the services sector, currently doing well.

What warnings emanate from more mainstream firms, tend to involve contract delays, e.g. Rolls-Royce having to caution that customers are waiting for a better-spec engine to become available, and Chime Communications incurring alleged temporary delays on its sports marketing side. With sports' long-term prospects said to be "very promising" and other divisions doing well, WPP has made a bid approach, possibly a straw in the wind, of big firms exploiting such warnings. They are challenged by a deflationary environment to grow underlying revenues, and most are cash-rich or within borrowing limits - hence profit warnings are liable to prompt takeovers. 

This is a good example how a "buy-and-hold" approach may need some adapting if deflation is getting more grip. Better be alert for special situations, i.e. stocks capable of trading more independently than the wider market.

Trading opportunities also in cyclicals

For long/short traders able to thrive on deflationary dynamics, cyclicals provide plenty of interest. Downside has recently manifested acutely in engineering groups serving the resources industry, e.g. Weir Group in the FTSE 100 index and Fenner being demoted from Mid 250 to small cap status. Interestingly, as regards possibly denoting a wider market top, Weir was enjoying historic annual average price/earnings multiples well into the mid-teens by 2013/2014, a typical sign that sentiment was overdone (ignoring cyclical risks).

At another extreme, Fenner's prospective dividend yield over 7% may show the market overly perturbed. If economic problems fester in China then stocks like this are best avoided for the time being; but such a view is why Fenner is being priced for a 7% yield, hence its stock will rise when the commodities' rout ends. Plenty of guesswork is involved but unless the downturn worsens then Fenner's dividend is covered by forecast earnings.   

A US bellwether cyclical is Caterpillar, a manufacturer of construction and mining equipment - lately hit by a 13% fall in second-quarter revenue, net income down 29% and full-year sales downgraded.  It's a good example how shifting demand from developing countries is a major risk also for the global economy and markets.  As with Weir and Fenner, pressures have gathered over the last two years with revenues down from $65.9 billion (£42.2 billion) to $55.2 billion and net income from $5.7 billion to $3.7 billion.

Yet these groups have survived well over an average 100 years, reflecting a culture able to cope with cycles. Caterpillar stock is still up about 10% over the past five years and by 37% over the last 10 years, besides a circa 4% annual yield. Returns could have been substantially enhanced by astute trading; why even if there is a sharper "risk-off" jolt to markets, well-established cyclicals that are market leaders will attract buying also. Such stocks can offer useful contrarian opportunities when investors get too greedy or fearful.

How long can the UK economic party last?

Second quarter GDP-per-head has risen from 0.4% to 0.7%, back to pre-crisis levels and putting an interest rate rise in focus; however, this is being driven by services such as retail, hotels and restaurants, while manufacturing output has slipped by 0.3%. Such a profile affirms one of my favourite UK-listed stocks, Young's which reports strong trading with total sales up 8.3% and like-for-like sales up 5.6%. The group's London & South East bias means solid trading is likely to continue, the last recession also showing that Brits won't compromise eating and drinking out - at a decent venue.

But it's worth a sober reflection that as George Osborne's public spending cuts put pressure on households and firms to fill the demand gap, consumer-related stocks could see some adverse effect. The UK economy remains imbalanced towards household consumption and property markets, than genuinely productive firms that export. Sterling is currently strong as the recovery has brushed debt fears aside; but it is early days to see the economic consequences of a majority Conservative government trying to streamline the state.

It all adds to the challenges of wealth preservation. Asset markets may finally be pricked by an interest rate rise, especially if deflation persists to hurt borrowers. A defensive stance currently implies a cash holding, to the extent appropriate for your risk tolerance, but mind how this can work against you in the medium term - if the UK's economic risks bring more volatility for sterling. There is no summertime relaxation chair!