The pace and the harshness of the economic slowdown have been extraordinary.  However, easy money has provided a powerful stimulant to equity and corporate bond markets.  Financial strains have begun to ease and confidence has stabilised but the ongoing weakness in money and credit trends signals that debt reduction remains a major headwind for many Western economies.

The major market rally, which began part way through the first half of 2009, has continued during the first quarter of this year, but many countries still have big fiscal deficits and unsustainably high debt levels.  The global system needs to restore a sense of economic balance.

The upcoming General Election in the UK will leave the Monetary Policy Committee in wait-and-see mode, as more transparency on the timing and extent of any post election fiscal squeeze is awaited. 

The UK’s exports do not seem to have been boosted by as much as might have been expected following the recent weakness in the pound and we do not see the exporting sector managing to offset the continued weakness in the domestic economy.  Indeed, we note that over half the UK’s exports still go to Europe and the recovery there seems to be waning.  In contrast, growth remains strongest in Asia, yet exports to this region are expected to account for only a little over 10% of total exports. 

Nonetheless, due to the extent of overseas exposure, the UK equity market looks attractive even if the economy does not.  Earnings growth and momentum look set to provide good support.

Global economic statistics point to a sustainable but patchy worldwide recovery.  Growth rates 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.

Given the attack on costs at a corporate level, we would expect operational leverage to drive a major cyclical rebound in many company profits, even if the global economic recovery is subdued.  Indeed, it seems reasonable to forecast as much as a two thirds increase in global earnings per share over 2010-2011.  In turn, good news on corporate profits should, in due course, overcome bad news on fiscal and rate fears.  Nevertheless, as stimulus spending is reduced, so a bumpy or even a turbulent market may develop and therefore dips might be bought but rallies should not be aggressively chased.

With decisive cost-cutting by US corporations into the economic downturn, the resulting sharp increase in profitability will continue to provide positive corporate headlines as the recovery develops.  Benefits of operational leverage lead us to remain focussed on cyclical sectors alongside a core theme of multi-nationals.  Despite apparently cheap valuations, it has seemed too early to overweight the defensives.  We continue to support quality companies that should show consistently better than average growth in what may prove to be an otherwise challenging environment.  The possible rise of protectionism could prove to be a double edged sword as it may risk extending the Western world’s woes for a long time to come but there are numerous businesses that should benefit from this shifting political environment.

At a time when sterling remains poorly valued, our view has been a positive inclination towards the strengthening of emerging market currencies over Western currencies, and hence a structural overweight towards Asia and emerging markets where we anticipate longer term earnings outperformance.  Prospects for sustainable growth seem much stronger in Asia and in resource rich nations, such as Brazil, Canada and Australia, but today’s relative valuations largely reflect this belief.

The Chinese renminbi seems likely to appreciate as the nation continues its unmatched economic progress.  Timing a response to an event such as this is notoriously hard.  Some weeks ago, a swift appreciation this year was becoming less likely, as weakness in other developed currencies, notably the euro, could have been seen as taking the pressure off Beijing to move quickly.  It would not want to dampen domestic demand just as government-fuelled stimulus programmes are coming to an end.  Beijing recognises that its future lies in domestic demand and it will, as a result, worry less about whether its currency can support its exporters. 

We favour multi-national exporters selling to China where its domestic consumption appears strong, alongside an environment for a sustainable period of appreciation of the renminbi, in contrast to direct investment where risks seem too great on a number of levels.  We favour companies that should benefit in an environment where Chinese inflation is rising, feeling that ultimate concerns over inflation will lead Beijing to allow the currency to rise at a gradual pace.  Here, currency appreciation seems a necessary impact of growth.

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 coming quarters.  We remain watchful of fixed interest markets with corporate bonds continuing to offer more attractive relative value in this asset class. 

In short, we remain optimistic about prospects for markets, though there are clear political and currency 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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