Investment Outlook
Investment Outlook - October 2010
The global system is struggling to restore economic balance. Despite this challenging background, global equities have been buoyant during the third quarter. Large fiscal deficits and unsustainably high debt levels form the basis of a great deal of investor apprehension and, with reports of China’s putative slowdown gathering pace in the second quarter, we witnessed volatility and weakness during the summer. Recent figures have allayed fears that the Western economies are facing a double-dip recession in the near term. The US dollar has notably lost ground against commodity‑linked currencies, as more robust economic data from China raised expectations that the huge demand for raw materials would remain intact.
It is unclear whether figures will continue to provide evidence of a solid pick-up in developed economies and it seems likely that the US Federal Reserve will look to loosen monetary policy further, probably by means of another round of so called quantitative easing or asset purchases. Indeed, the Bank of Japan has begun a process already and it possible that the Bank of England might also follow this path. There has been a major disconnect between bond markets and equity markets in the recent past and we feel that some appealing equity market valuations have materialised, as a result of this nervousness.
Inflationary dynamics across major and minor economies are progressively more diverse. By way of example, commodity prices (both soft and hard) are generally firming, whilst levels of excess economic capacity, notably in many economies of the West, are particularly high. Indeed, unemployment remains persistently high in both Europe and the US. It is suggested that recent fiscal tightening may hasten the descent into an even more deflationary period for the US and UK and we do not disagree that a short period of deflation may materialise. However, the unprecedented economic stimulus packages and continued low interest rates are expected to distort decisions and pose further risks to financial stability. The likely response to such a turbulent situation is the printing of yet more money with consequent inflation risks in the medium term.
There may be legitimate concerns about the softening of economic data in the coming quarters and we have long felt that this healing process would be both patchy and bumpy, but that global economic statistics point to a sustainable worldwide recovery within which asset prices can continue to respond positively as confidence stabilises.
10-year government bond yields rose a little in the major western developed economies in September, but remained at a very low historic level. The US yield curve steepened a little. We expect the 10-year Treasury yield to remain around 2.5% for the immediate future, as their interest rates remain on hold.
If the Federal Reserve were to generate inflation, perhaps with the help of a weaker dollar, then owning longer dated Treasury bonds at their current low yields could prove a formula for significant losses in coming years. Should the Federal Reserve become a big buyer of bonds again, this may pull yields yet lower in the near term but there will come an inflection point when inflation starts rising. Indeed, there will come a time when central banks will sell their bonds and arguably markets are at present being heavily distorted and this makes it difficult for investors to assess the value of future cash flows.
The UK equity market looks attractive, even if the economy does not. The impact of the new coalition government’s comprehensive spending review will be far reaching and at present UK economic growth is forecast to be sluggish at 1.5% in 2011 and 2% in 2012, whilst earnings growth and momentum look set to provide good support. Dividend growth has returned and prospects for dividend growth next year are good. Indeed, double digit UK dividend growth seems likely in 2011. It will be important to watch BP’s expected return to dividend distribution and to be mindful of the US dollar/sterling rate, as more than 40% of UK dividends are declared in dollars.
All the major sectors of the US market have shown gains in September and the defensive sectors, such as utilities and consumer staples, underperformed. There seems to be scope for further useful price/earnings multiple expansion, particularly if confidence continues to return. Conspicuously, many cyclical stocks currently trade at a similar earnings multiple to defensive stocks, which is unusual. Most recently, emerging market equities have outperformed developed market equities in dollar terms. This was led by Emerging Europe and Asia ex-Japan. Indian equities have also been very strong. Risk in these emerging markets remains high.
Upward pressure on the Brazilian real led the country’s finance minister to warn of a global “currency war”. The Chinese authorities have been more tolerant of renminbi appreciation against the dollar in September, but there has been an apparent reluctance to let the Chinese currency appreciate and there seems to have been much interventionist activity in the currency markets. Indeed, the Japanese authorities confirmed that they intervened on the foreign exchanges for the first time in more than six years in an attempt to stem the yen’s rise. Nonetheless, the yen does not look especially overvalued in real trade-weighted terms. The spectre of more protectionism and of international trade wars may be looming.
Agricultural commodities, such as sugar, cotton and corn, have seen sharp price rises. The price of wheat, which had rose significantly during the summer in response to severe droughts in Russia and neighbouring countries, fell back a little. Oil, which has been in a trading range of $70 - $85 a barrel for a year, looks set to test that upper level in the coming weeks.
Mergers and acquisitions look set to continue apace, with many large companies now generating strong cash flows, meaning that they should be capable of driving significant market consolidation or of returning funds to shareholders through improving dividends or share buybacks. Corporate margins staying high and the delivery of profit growth, coupled with the market’s marginal buyer being the corporate sector, should provide good near-term support to the equity market.
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