Investment review for the first 6 Months of 2010

July 28th 2010

The view 12 months ago was ‘we believe the economic recovery is likely to be patchy and protracted’ but that ‘the gloom will be punctuated by sporadic rallies in equity markets, over the coming months with equity markets likely to trade across a wide range’ . That range turned out to be 10% wider than most expected, with the FTSE 100 trading between 4200 and 5800 points. The recent rallies have also been accompanied by a surge in volatility back to the levels of a year ago.

 

Sadly, there has been little in the economic data of the last 6-9 months to materially alter that view. Whereas 12 months ago many managers felt the risks were equally poised between a sustained recovery and, a delayed/weakening recovery, it is now thought the risks at present are weighted slightly in favour of the later scenario. This is not a ‘double dip’, which in many minds means a contraction or negative growth in economies, rather, more subdued growth in GDP of circa 1-2% or so.

 

GDP growth in developed economies picked up during the later part of 2009 and early 2010, with growth rates for 2010 set to be circa 1% in the UK, 1.5% in Europe and nearer 3% in the US, with similar or marginally lower rates of growth expected in 2011. In the case of the UK this is half the rate of growth of the last decade. There are concerns that the current forecasts for GDP growth may be revised downwards as we near the end of 2010.

 

Even after 2 years of recession and massive fiscal stimulus adopted by most Governments, the ‘recovery’ remains fragile and muted. It seems inevitable that the QE policies adopted in the UK and elsewhere will need to be extended for some time yet, however it cannot continue indefinitely. It looks like growth will remain anaemic as consumers continue to save (pay down debt) and unemployment continues to rise. Interest rates seem set to stay close to current levels until well into 2011 and, if economic activity weakens, then for longer still.

 

Investors have begun to look closer at Government finances in recent months given the eye watering scale of the bail out of the last 2 years. We have seen with Greece recently what may well be the first of a series of sovereign debt crises over the next 18 months, as the costs of servicing the vast government debts rise and investors periodically question the solvency of some countries.

 

Recent weeks have seen a swathe of European Governments announce ‘austerity budgets’, cutting Government spending, in order to reduce their deficits and reassure investors in their bonds that the deficits are being actively managed in a responsible manner.

 

A quick aside on the Euro – most observers do not currently believe the Euro will unravel as the political and economic implications of it doing so are such that current Governments will do what is necessary to ensure its survival. Whilst one or two smaller members may be forced to leave, a stronger Euro will emerge in due course, assuming that the recent steps on reducing budget deficits are followed through during the coming years.

 

The growing concern investors do have is the increasing difference in policy being adopted by European governments and that of the US in respect of their deficits. European governments are starting to cut spending whilst the US urge ever increasing spending. Both approaches cannot have the same outcome and whilst it may well just be a matter of timing such fundamentally different actions should remind us how unchartered the economic territory is that we are currently find ourselves in and, that there are likely to be some currently unforeseen consequences to these actions which will result in heightened volatility in markets at some future time.

 

Fundamentally, the core issue remains the same as it has been since 2007 – there is too much debt in the World and reducing that debt to a sustainable level will take time and cannot be achieved without some difficulties along the way.

 

On the positive side equity markets are currently not expensive by historic standards, although with GDP growth rates expected to be below average for the next couple of years one perhaps needs to temper ones enthusiasm a little. The average Price to Earnings Ratio of the UK stock market over the last 25 or so years has been around 13.5x and for the US stock market nearer 17x, so current expectations indicate some value relative to the longer term numbers.

 

Recent falls in equity markets meant that for only the 3^rd time in 10 years the yield on the UK stock market has exceeded the yield on 10 year Gilts; the 2 previous occasions, March 2003 and March 2009 on which this occurred proved to be an excellent ‘buy signal’ for equities as the UK stock market gained an average 40% in the subsequent 12 months.

 

Staying with the positive, developing economies (Pacific Rim, India, Brazil) seem set to grow at double the rates currently forecast for developed world economies and these regions could therefore continue to have significant appeal to investors.

 

However, investors need to be alert to the fact that if there is not a continuing shift from export led actively towards more domestic demand then the attractions of these markets will be reduced and the risks of material disappointments for investors increases. As a sign of changing investor sentiment seems the most awaited and probably most analysed GDP numbers are now those from China given the importance and almost mythical nature of their  8-10% annual growth in GDP.

Perhaps the biggest scope for positive news comes from corporate balance sheets which amongst the largest companies are at their healthiest and carrying the biggest amounts of cash in a decade or more. If company capital expenditure picks up at a faster rate than many expect (or hope!) then that would have a material impact on economic activity and investor sentiment.

 

Global economic activity in the next 3-4 years will probably be below the average of the last 20+ years.

 

Equities look attractive in the short term given valuations and the current momentum in corporate earnings, not forgetting 0% interest rates. Stock markets seem set to continue trading across a wide range and managers must remain alert to the peaks as there is a risk that the inventory cycle runs its course in late 2010 and that earnings growth slows which is likely to be a catalyst for stock markets to fall as investors adjust their outlook for 2011 downwards.

 

Government bonds look at unsustainably low yields in the medium term, given the size of Government deficits and scale of bond issuance needed to fund even reduced spending plans.

 

Currencies are likely to remain volatile in the medium term given the global nature and scale of the credit crunch and subsequent recession

 

Volatility in investment markets is very likely to remain higher over the next year or two reflecting the extraordinary nature of recent economic events.