A case of sell defence

As US war planes head for the Gulf some fund managers are baling out of military stocks. Patrick Collinson explains why

Special report: attack on America
Special report: global recession

There's a war coming! Buy military and defence stocks! Sure enough, when the New York stock exchange opened on Monday, defence shares jumped as nearly everything else plunged.

Investors couldn't have got it more wrong, according to New York-based Susan Everley of Credit Suisse. She manages $5bn in US stocks, including Credit Suisse's Transatlantic fund, one of the most popular funds for British people investing in the US.

She returned to her desk in mid-town Manhattan this week and immediately started selling out of defence stocks. One of her first moves when the NYSE opened was to sell most of the fund's large holding in Lockheed Martin, makers of hi-tech military systems.

"Lockheed Martin was one of our biggest positions during 2000 and most of 2001. Valuations are near a peak, having risen from around $17 to $40. We felt that given the valuation, and the fact that it went up a further 13%-14% on Monday, it was sensible to sell out."

She is not alone. Another top-performing US fund, Clerical Medical's American Growth fund, was also ditching its holdings in Lockheed Martin last week.

James McLellan, part of a team at Clerical Medical which runs $4bn in US equities, said: "We have made some opportunistic changes to the portfolio, taking profits on defence companies, which have been good stocks over the past year anyway. We sold Lockheed Martin, which was rising as part of an emotional reaction to last week's terrible events."

The biggest unknown for many investors is how the US consumer will react to the assault on America. David Gasparro, chief investment officer for Schroder's retail funds, says: "The key consideration is whether this will undermine consumer spending. Given the importance of the consumer in keeping the US economy going over the past year, there are concerns that a slowdown here could push the US and the global economy into recession."

But for Credit Suisse's Transatlantic fund, the discussion is somewhat academic. "What happens to consumer confidence is unlikely to change our outlook," says Ms Everley. "We were very negative on consumer stocks before the events, and coming out, we are even more negative. We had taken many of our consumer weightings to zero."

The decision to quit big-ticket consumer goods companies had been taken months ago because of the warning signals in the employment figures. "We were watching lay-offs closely, with weekly claims at the 400,000 level signalling a recession."

Rising unemployment, and its wider impact on workers' general sense of insecurity, results in a sharp fall in demand for items such as cars.

So what are US investors such as Ms Everley buying? Small-ticket seems to be the answer. Ms Everley's shopping basket contains fizzy drinks, pet food, bleach, razors and fags. In other words, her biggest holdings are now Coca-Cola, Clorox (makers of pet food and bleach), Gillette and Phillip Morris. "They are the staple sorts of things that people will continue to buy in a recession," she predicts.

So Credit Suisse believes a deep recession is on the way? "The events of last week definitely push out the prospects of a recovery. We were expecting the third quarter to see the trough in earnings, but now that has been pushed back to the fourth quarter at least, and we will see negative GDP growth."

But it's far from doom and gloom, with the medium-term outlook now looking better. "Before the events, we had already had monetary stimulus from the Fed, with perhaps another 0.25% further to go on rates, plus there was no more fiscal stimulus expected. Now we have the opposite; we have the Fed acting more aggressively, and a global environment of co-ordinated monetary easing. And on the fiscal side, we have the government saying there will be emergency funds made available."

Fidelity, the world's biggest investment company, is optimistic about the longer-term impact of rate cuts and improved liquidity in markets. It says: "The Fed's interest rate cut was prompted by weakness in employment, industrial production, and business confidence that had already been observed before last week's terrorist attack.

"Nevertheless the Fed also sent two key messages: first in the short-term, it is ready to act to supply ample liquidity to the markets and lower interest rates. Second, in the long run, the Fed believes the 'prospects for productivity and the economy remain favourable'."

One small British investment management company, Solus, is so confident that it is launching a fund on October 1 that will buy into "special situations" as the US stages a robust recovery. A Solus spokesman says: "It is extremely rare to see the the US economy in recession, and for markets to fall, for two years in a row. We think the market could bottom out in as little as four to six weeks' time."

Standard Life, one of the biggest investment managers in Britain, also provides some comfort for nervous investors. Andrew Milligan, its head of global strategy, says: "Valuation levels of equities in comparison with bonds have become much more attractive. Equities are now either attractively or very attractively priced."