With consumers set to be squeezed after the 2010 election, supermarket shares may not prove to be as defensive as they used to be.  Stockmarket folklore has it that supermarket shares are defensive because people always need to eat and this held true in the days when supermarkets only sold groceries.  But these days supermarkets sell far more than just groceries.  With Tesco taking one pound in every eight spent by British consumers, they will not be able to escape the effects of consumers battenning down.  It is true that food retailers are shifting their offering downmarket in an effort to follow their customers as they trade down in tough times.  However not every food retailer will be able to protect their sales volumes & profits in this way.

Sales of organic produce fell 14% in 2009, indicating that consumers are already trading down, with organic meat sales being hit hard (beef down 25% and chicken down 28%).  Consumers may buy organic & ethically produced food when they feel they can afford it but with the Food Standards Agency stating that there is no scientific evidence that organic food has health benefits, when the squeeze comes consumers will trade back down quickly.

The pain thus far has been felt most by those people who have lost their jobs during the recession.  As interest rates have been cut sharply, the vast majority who are employed have seen their monthly budgets improve as mortgage payments have fallen.  However any post-election tax increases are going to be felt by all 29 mln employed people in the UK (and their families) and this effect will be very broad-based indeed.  The supermarket shopper is going to look to cut back even further and now that the weaker retailers have already gone bust, the one-off boost to the survivors’ sales has already been seen and all are likely to suffer.

The counter-argument to this is that consumers will cut back on eating & drinking out and spend more on their weekly grocery shop instead. This will affect the pub & restaurant sector (which has already de-rated in anticipation and offers better value than supermarket shares).  It remains to be seen what consumers will choose to do when the squeeze is applied by a government seeking to get the budget deficit back under control, but investors should choose to invest where the risks have at least been somewhat discounted and upside is on offer.

However with Tesco, Sainsburys and Morrisons all trading on 13x estimated 2010 earnings, yielding 2.9%, 4.1% and 2.1% respectively, these shares are not a Buy.  If you feel compelled to hold a food retailer then SBRY yields the most and benefits from periodic bouts of takeover speculation.  Much better value is available elsewhere in the market and owners of TSCO, SBRY or MRW should sell out of them as they are too highly rated, still trading within 8% of last year’s highs, and do not offer sufficient upside to compensate for the risk that their sales start to suffer later this year as consumers begin to be squeezed.

The key issue for the markets to contend with in 2010 is the risk that the economy slips back into recession (the so-called “double-dip”).  As the banks have now been largely fixed, should the economy double-dip then it is likely the retailers will be foremost amongst the suffers.   

The retail sector had a strong rally last year as the stockmarket discounted a recovery.  If we use MKS as a proxy for the sector, they rallied from just above 200p in Dec 2008 to finish at the 400p mark, with the annual dividend cut to 15 pence along the way.  The risk now is that the consumer gets squeezed after the May election and consumer spending suffers as a result.  Even if consumer spending does manage to hold up, the sector has already priced in a recovery and there is not enough upside left to reward investors sufficiently to risk owning the shares.  If the sector continues to trade lower then at some point it will make sense to buy back in for the next recovery trade.

A second sector to be very careful of in 2010 is the pub & restaurant sector.  Wet-led tenanted operators such as ETP and PUB are going to continue to struggle whilst their food-led competitors MAB and MARS may fare relatively better.

It is likely that a newly elected government will both cut spending and signal tax rises once the economy is strong enough to bear them. The Government has a massive hole to fill in, net borrowing will end up somewhere around £175 bln in 2009/10 and £180 bln is forecast for 2010/11.  The fact that this is 12.5% of GDP does not tell the whole story as it also represents 39% of pre-credit crunch tax receipts.  The government’s income has fallen by 12% over the past two years but spending has yet to be cut by a single penny.  The emperor has no clothes – Gordon Brown will not countenance spending cuts and doesn’t have any money to “invest in services”, whilst the best David Cameron will be able to do is maintain spending on the NHS and cut spending significantly everywhere else. 

Take a minute to think about the mountain that needs to be climbed in the UK.  Central government total tax income is forecast to be £397 bln in 2009/10.  Adding on £175 bln net borrowing implies total government spending of £572 bln.  In the best year ever, total taxes raised were £451 bln (2007/8).  Its going to be a long, hard slog to get back onto an even keel and it will take years to fill in this particular hole via a combination of spending cuts, tax rises and hopefully renewed economic growth causing the tax base to grow as well.  The Bank of England will wait a very, very long time before risking any rate rises against this backdrop – it is more likely that QE will be resumed (from its current £200 bln) to support the economy/gilts market before any QE exit strategies are implemented.

At the moment the retail sector carries all the risk of being first in the firing line should consumer spending weaken and lead the wider economy into a double-dip recession.  Avoid retailers until the sector offers patient long-term investors a much better risk/reward.

One year on from the bankruptcy of Lehman Brothers and we have seen global stockmarkets spend six months plummeting to a low in March 2009 and then another six months rallying back again.  The Dow and S&P are now 15% below the levels at which they stood on the Friday before Lehman went bankrupt on the weekend of September 15th 2008.  The FTSE is just 5% below its close on the eve of Lehman’s bankruptcy.  We are still amidst the fog of war and nobody can quite work out whether stockmarkets are now too high following the impressive 50% rally since March or whether stockmarkets still have room to rally because an economic recovery may be starting (which then leads to an argument about whether the stockmarkets will fall again next year should there be a double-dip recession).

If we track back to the week before Lehman went bankrupt then stockmarkets had already fallen 20% from their highs in October 2007 and they were discounting some type of a recession and had not yet begun to rally in anticipation of an economic recovery.  The bankruptcy of Lehman changed the outlook so severely that markets sold off savagely to discount some type of 1930’s-style depression (with leveraged players being forced to liquidate which pushed share prices down even further).  The governments and central banks stepped in with some determined spending of taxpayers’ money and as the spectre of a depression has receded, stockmarkets have rallied back to their current levels (which are still below where they were on the eve of Lehman’s bankruptcy).

So have stockmarkets rallied too far or do they still have room to rally some more?

Although markets never move anywhere in a straight line, it feels as if they still have room to rally further as the tentative economic recovery which has begun goes on to establish itself more firmly.  Given that on the eve of Lehman’s bankruptcy markets had not yet even begun to discount an economic recovery then in order to discount whatever shape of economic recovery we are about to experience, stockmarkets should logically be higher than where they were in early September 2008.  The US and UK are likely to report positive economic growth for the quarter just ended when GDP data is reported for Q3 2009 and only time will tell whether they go on to report another quarter of growth in the final quarter of 2009 (see One Quarter at a Time).

So stockmarkets may well continue to climb the current Wall of Worry for the next couple of quarters and we can then start to consider the possibility of whether there will be a double-dip recession in 2010.  Although central banks continue to print money and interest rates will stay rooted near zero for a long while yet, a sense of normality is starting to return to corporate life with takeover activity returning to stockmarkets (Kraft/Cadbury and Balfour Beatty/Parsons Brinckerhoff being just two recent examples) and companies are finding it possible to raise equity capital (even though they are most unwilling to get deeper into debt).

Tentative it may be, but the recovery (which may well be long, slow & grinding) is only just beginning.   The fog will clear from the battlefield over the next few quarters and investors will be able to assess things more clearly.  The bad memories of the last year are still fresh in investor’s minds but stockmarkets look forwards, not backwards.

Stockmarket rallies are said to climb a “Wall of Worry” as the stockmarket climbs higher in spite of the various problems that already exist or may be about to happen.  There will always be many Cassandras and Perma-Bears out there highlighting the many reasons why the stockmarket is too high and is riding for a fall.  The vast majority of the time they are wrong but they have their day in the sun when the market does indeed fall (often after having risen substantially since the bears originally started shouting about their worries).

The reality is that stockmarkets broadly follow the economic cycle as GDP expands during times of economic growth (which happens most of the time) and as GDP contracts during recessions (which rarely last long but do cause sharp and painful falls in stockmarkets in the order of 30% to 50%).  When a recession ends the problems of the downturn are still fresh in people’s minds and it is these worries that the stockmarket’s rally overcomes.

The Fed made it clear to the market with this week’s FOMC statement that speculation of a rise in the Fed Funds rate anytime soon is completely misplaced.  The Fed pointed out that with US GDP still contracting the economy has not yet even begun to work through the vast amount of slack in the system (capacity utilisation down near 65% and unemployment at 9.4%). It is this same spare capacity that means they are also not worried about the recent rise in energy & commodity prices feeding through into a sustained rise in inflation.

Even when US GDP starts to grow again (possibly later this year given that excess inventories now seem to have been worked off by manufacturers) it will take many quarters to chew through all the slack in the system (and the US economy has yet to contend with Obama raising taxes/allowing the Bush tax cuts to expire).  Therefore the FOMC “continues to anticipate that [the Fed Funds rate will stay at 0.25%] for an extended period”.

Those who think that the economy will bounce back strongly and that the Fed will soon be taking back some of its rate cuts should watch what the Fed does when it completes its $300 bln purchase of Treasuries in the autumn.  If the Fed announces it is going to spend additional money buying Treasuries then rate hikes will stay off the agenda.  Stock markets have bounced and bond yields have backed up as financial markets have regained their poise this year after the carnage inspired by Lehman’s bankruptcy last autumn.  Markets have gone from pricing in a depression to pricing in a prolonged recession and equities are currently consolidating after their sharp rally off the March 2009 lows and digesting the supply of fresh equity from corporates who are either getting their balance sheets back into shape or raising funds to take advantage of opportunities they see in the current environment (banks are not lending and credit spreads remain wide so equity is currently the default source of funding).  This is why the “green-shoot spotters” are out in force at the moment as the next move in the markets will be driven by perceptions of economic recovery or a slip back into a W-shaped recession.

For the foreseeable future the Fed continues to stimulate the economy by keeping rates close to zero and buying up Treasuries & mortgage-backed securities.  It will keep the pedal pressed firmly to the metal until the economy has grown sufficiently to have taken some of the slack out of the system.  Anyone expecting the Fed to hike rates the instant GDP starts to grow again is going to be disappointed (it is not going to repeat the 1997 Japanese mistake of raising taxes and snuffing out economic recovery the instant it has started)- a better guide to the timing of a rise in the Fed Funds rate will be given when the unemployment rate is at least two percentage points off its high and capacity utilisation is above 75% and the Fed has seen what impact any Obama tax increases have on the economy.

With the changing of the US presidency, the market has been offered a new hope that Obama may be able to soften the depth of the current recession by helping the banks, getting stimulus legislation passed & generally making consumers feel better because they can feel optimistic about the future.  We have no idea whether Obama will be a good president or not, but the US people will naturally tend to hope for the best now that Bush has departed.

As ever in financial markets, this is all about confidence.  In the short term it doesn’t matter whether a US Bad Bank will make things better or not, merely the confidence that it will causes the financials to rally.  Whether the rally eventually holds depends upon how workable the scheme proves to be – there is no point killing the patient by buying dodgy assets off them at such a low price that the writedowns incurred bankrupt the bank.  This is the advantage of insuring suspect loans rather than buying them off the banks.

The evidence that the market is currently using confidence to price banks, rather than some form of expected p/e ratio, can be seen in the performance of BARC (in particular) over the past two weeks.  Its share price plunged over 20% in the last hour of trading a fortnight ago to close at 98p on Friday 16 Jan, below the prior 128p closing low of 20 Nov 2008.  This prompted the BARC Board to pre-announce 2008 earnings of £5.3 bln over the weekend.  The share price duly rallied when it opened the following Monday but this rally petered out quickly and within 2 hours the shares were back down at 100p; they then went on to halve during the rest of the week and closed at 51p on Friday 23 Jan.  The fact that the shares could not sustain a rally and fell to fresh lows after the company announced earnings were going to be better than expected was proof that the market was valuing BARC on confidence, not earnings prospects.  The BARC Board clearly had a re-think over the weekend and published an open letter, clearly spelling out the capacity of BARC to absorb future losses from bad debts without turning to anyone (shareholders, Middle East petro-dollars, the UK Government, etc.) to raise fresh equity capital, and clearly stating that BARC were talking to the Government about insuring some of their loans.  The UK Government’s proposal to provide insurance against dodgy bank assets was key in making the BARC statement believeable, and BARC have doubled in price back up to 100 this week.  The sting in the tail for BARC management is that buried in the detail of the Government’s announcement about providing insurance to banks is a statement about the Government requiring a say in remuneration policy…but I don’t think many people are going to shed a tear about Bob Diamond being paid less than 20 million this year.

 At least we can look at the 44th US President and hope he manages to instil some confidence.

Post Script:  During the week when bank share prices troughed (with BARC around 50p & RBS around 13p) Paulson & Co closed their short position in RBS.  Hats off to them for shorting high, riding the short down through two rights issues and not forgetting to close it near the bottom.