On the surface it has been a remarkable few weeks, but the current market volatility should not come as a surprise. It is probably another example of what some analysts have called a growth scare. These bouts of volatility typically pop up as the markets reassess the valuation of risky assets against constantly changing growth trends (currently trending downwards).
At the moment I would discount the more downbeat forecasts which suggest a massive collapse is on the cards. The saner analysts simply believe that any future macro-economic growth in the major Anglo-Saxon economies over the next 12 months will be lower than first expected and that the UK, in particular, looks mired in sub-1.5% GDP growth for a good many years hence.
Conversely, a welter of anecdotal evidence suggests the economy may not be in as bad a shape as the macro-economic numbers suggest. Employment growth is slowly picking up, profits are riding high in some sectors and many business leaders seem quietly confident about the future, provided we can all survive without a financial meltdown in October or November.
In fact, what has really changed in the last few weeks? It’s true that more of Europe is in trouble than in the early summer. It’s also true that the political elite in the major European capitals continue to ignore the justifiable concerns of the bond vigilantes. But all of this was true six months ago and will be true in six months time. Italy will not default and the politicians in Germany will eventually be forced to underwrite a massive Eurobond issuance programme to stabilise the euro.
Equally the American ratings downgrade is no surprise. It simply underlines existing long-term worries about US solvency. We should not overplay these worries, if only because worried investors still continue to buy US government bonds as a safe haven.
Back in the consumer economy, sentiment remains subdued, household finances are dreadful and the US Federal Reserve has confirmed a dirty secret in financial circles which is that US (and thus UK) interest rates will remain at extraordinarily low levels for many years more. Again, no change there.
Markets turn away from big two
Yet two trends have reversed in recent weeks, and both are of major importance. The first is the view on inflation, with the deflationary hawks (those who worry about falling prices) in the ascendant. This matters because it will have a massive effect on commodity prices, which have already fallen sharply.
The other change is that the equity markets have started indulging in one of their periodic spasms of fear and panic. These retreats from risk see whole sectors vanish from the herd's radar, marked as off-limits to all but the hedge funds which love to short-sell stocks. The small and already unloved travel sector now finds itself in that category, and we are fast approaching the point of what is called ‘capitulation’, where no one can even be bothered to express a view on companies such as Thomas Cook or Tui Travel.
This brings us to the most remarkable action of the last few weeks, namely the humbling of Thomas Cook and the disinterest in Tui’s recent trading numbers. Thomas Cook is now essentially a binary bet. If we’re to believe the analysts’ numbers, Thomas Cook yields over 15% and is trading on a price-to-earnings ratio of low single figures. No one believes these numbers which is why last week Thomas Cook’s shares fell by more than 12% in one day before rebounding.
The markets are essentially saying Thomas Cook is either incredibly cheap or virtually worthless. If it's the former, the stage is set for a remarkable rally which is likely to consist of bargain hunters squeezing out the huge short interest that has developed. Sooner or later market gossip will prompt a private equity bid for the travel giant and the shares might suddenly shoot back up in value.
If on the other hand Cook is virtually worthless, the share price will crash past a key support level that is written into the debt covenants, instantly triggering what might be described as ‘discussions’ with the bond holders. These discussions usually consist of the bond holders telling everyone else what they are willing to agree. They might, for instance, ‘suggest’ that because the equity in the company is valued at such a pittance they grab the remainder, leaving existing shareholders with nothing, or maybe 5% to 10%.
I have no idea what that equity-to-debt trigger is – I had initially wagered it was around a market cap of £500 million, but clearly it is lower than that. The worry for Thomas Cook is that any announcement to stop the dividend will prompt a sudden sell-off which pushes the share price below 40p, which could in turn encourage the short sellers to push down the share price even more. God forbid if that announcement came on a bad day for the markets.
As for Tui Travel, the only sensible view has to be that the market has the industry leader almost completely wrong. On the day following the release of a decent set of numbers last week, Tui Travel’s shares plunged by more than 10% to close a shade over 150p before staging a modest recovery towards the end of the week.
Chief executive Peter Long sensibly avoided any gloating over the troubles at Thomas Cook, but one can’t help feel a bit sorry for him. The group’s strategy seems to be working yet no-one appears to care. Sadly this ignorance and disinterest can persist for years – the major drug companies have been in the doldrums since the middle of the last decade as the markets fret about the absence of any new blockbuster products.
What should the travel sector watch out for in the coming months? The biggest issue is whether the US Federal Reserve decides to launch a new bout of quantitative easing, otherwise known as QE3. In my view this will be badly received. It will tell everyone that US growth has collapsed and that the authorities think they can pump-prime the economy again. No investment or hedge fund manager believes that, and although the initial reaction to QE3 might be positive I’d expect a massive sell off by the end of the year, with a real chance of a meltdown in 2012.
The travel sector should also keep a close eye on commodity prices and especially oil costs. The chances of a deeper fall in crude oil prices are growing, with $75 a barrel likely to be tested within months, followed by $60. If the global economy is slowing and China continues to decelerate I wouldn’t want to be caught anywhere near the commodity sector as an investor.
The last key force is the consumer. The consensus view is incredibly pessimistic, but I’d be on alert for more positive trends as inflation fears recede in the wake of falling energy and food prices. Employment growth might also speed up and it’s even possible the UK government might reconsider some selective tax cuts to spur demand. If all goes to plan, the Olympic year 2012 could turn out to be a good year for consumers.
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