The global economy has endured an abnormal undershoot in economic activity, but this has set the scene for a rebound, as financial strains have begun to ease and confidence has stabilised. 

Thus, the bear market, which we were witnessing at the beginning of 2009, turned into a major market rally part way through the first half of the last year and continued strongly in the second half of the year.  Fiscal and monetary reflation prevented the major economies from sliding into a 1930s style depression.  Aggressive policy responses have provided a foundation for economic stabilisation and the subsequent re-rating of risk assets.  Whilst the policy of ‘quantitative easing’ and stimulus has been continued in both the United States and the UK, it seems likely that the majority of funds allocated for this purpose have now been spent and governments have paid the price of crisis management with many countries now having big fiscal deficits and rising debt levels.

So, the major western countries need to spend less and save more, while Asia, and especially China, seemingly need to do the opposite as the global system looks to restore a sense of economic balance.

Economic data series that illustrate growth rates currently look very V-shaped.  The same is true for distribution indices, such as purchasing managers’ surveys.  At the lows, an extremely high percentage of companies were reporting declines in orders, employment and output, so it was not difficult to register a healthy bounce from such unusually depressed levels.  However, the improvement in the level of activity has been modest relative to the severity of the decline.

The global economic revival is, in our view, sustainable, but it seems likely to be both patchy and bumpy from here.  We believe that the US and Emerging Markets will lead and that Europe is probably going to lag.  The huge cost of bailing out the financial sector and a fragile recovery will continue to menace and threaten.

In assessing risk, we feel that the time is approaching where we must prepare for the end of deflationary forces.  Indeed, it seems possible that UK may go through a period of major fiscal deficit and persistently higher inflation.  If there is an ambiguous result in the forthcoming General Election, this could also spark a sovereign debt downgrade and further currency weakness.  What has clearly not yet fed through to inflation is the impact that the stimulus will have when the velocity of money increases in the years ahead.  Further, we continue to fear that the additional government bond issuance required to fund the stimulus may further depreciate the major currencies (essentially Sterling and the US Dollar) against those of their creditor nations (such as Japan and China).  The Federal Reserve has vowed to keep short term interest rates extremely low until the US economy gains strength – which may not be until the second half of the year or later (but, in our view, months not years).

Although there is currently little inflationary pressure across the major economies, several market indicators suggest to us that inflation is likely to spring back in the coming quarters.  We remain watchful of fixed interest markets with corporate bonds continuing to offer the more attractive absolute and relative value in this asset class.  Whilst the magnitude of expected returns may appear small, there is certain appeal given the lower risk and volatility of the asset class when compared to other risk assets.  Stocks of a shorter duration should be less vulnerable to future interest rate rises and any resurgence in inflation.  We are warming to the longer term attractions of index-linked securities, as a potential portfolio hedge against this threat.

Cash flow into equities is expected to be strong, particularly given low returns from cash, and it is our feeling that this should help drive outperformance of the largest stocks.  Liquidity will play an important part in determining performance in coming months.  We are prepared to continue to support quality companies that will be able to show consistently better than average growth in what may prove to be an otherwise challenging environment.  Superior growth should lead to superior share price ratings and in many cases the prospect of a further upward re-rating.

The equity rally that we have witnessed to date appears primarily to have been a value driven recovery and therefore a revival trade.  The expansion of price/earnings ratios from the depressed levels in Spring 2009 has been firmly at the core of market performance.  Businesses with growth, solid balance sheets and sustainable, progressive dividends seem more likely to provide reliable future returns. 

Multi-nationals, but by no means all, form a key theme in this environment.  Makers of consumer staples, with higher exposure to some of the growing markets of Asia and Latin America, are considered particularly desirable.  Indeed, we support increasing exposure more generally to global assets.  Prospects for growth seem much stronger in Asia and in resource rich nations, such as Brazil, Canada and Australia, but relative valuations are beginning to reflect this belief.

In short, we remain optimistic about prospects for markets, though there are clear political risks around the upcoming UK election.  We maintain a negative bias towards purely UK-orientated stocks, especially companies exposed to government expenditure and the domestic consumer, given the undoubted headwinds that will be experienced during the coming year.



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