By NIGEL PARSONS 12/06/2009
"A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty"
WINSTON CHURCHILL
As we move into the traditional summer lull, the fickle nature of investor psychology has once again come to the fore. Hopeful that the fine spring will nurture the green shoots of recovery, sentiment has flipped between dire pessimism and wild exuberance more often than an MP flips their second home. It is against this backdrop that we have concluded our latest asset allocation meeting, and we thought it might be helpful to provide you with a synopsis of our views.
Review and Outlook
Equities
Although equity markets have rallied from their March lows on recognition that an economic meltdown and prolonged depression is now unlikely, we remain of the opinion that the recovery will be protracted and that equities offer only fair value. Whilst some rebuilding of inventories was inevitable from the lows of 2008, high levels of consumer debt and unemployment are likely to stifle final demand; demand that will remain below trend for some time to come as we borrow from tomorrow to fund today.
While equities were right to recover from their previous depression scenario, any significant rally from current levels would run the risk that we overshoot on the way up. We are therefore only making modest changes to our asset models, increasing equities very slightly in recognition that market movements will have already boosted this element of portfolios. Global growth will likely remain subdued as the developed ‘deficit’ countries deleverage, whist the ‘surplus’ developing countries remain dependent on exports to the heavily indebted western economies. Within our equity weightings, we are increasing our exposure to Asia and the Emerging Markets, at the expense of the developed nations, as we view these as the main drivers of economic growth going forward.
The imbalances between the surplus and the deficit nations will take years to fix as it requires a role reversal between exporters and importers, savers and borrowers. In this environment, and given large levels of excess capacity, we do not anticipate inflation being a problem for some years. This is critical to our asset allocation and distinguishes us from consensus. Although rising energy prices are placing upward pressure on inflation expectations, this is not enough to offset the growing negative output gap and squeeze on profit margins; inflation in the near term remains a non-issue.
Bonds
This benign outlook for inflation has allowed us to remain positive on fixed interest, despite the narrowing spread investment grade bonds offer over treasuries. Similar to equity markets, pockets of value continue to emerge within fixed interest, with the stabilisation of the banking sector in particular now providing good opportunities in financial debt. Although generally, investment grade bonds offer superior risk-return profiles than equities, a lack of quality and liquidity keeps us cautious towards high yield bonds.
Even though economic activity appears to be close to bottoming out, the demand for corporate credit remains low. Although much has been written about quantitative easing, the process thus far has achieved little more than providing a counterweight to the deleveraging taking place in the financial sector. Whilst this has helped liquidity return to credit markets and arguably prevented a global recession developing into a depression, it has not yet boosted overall demand. With bond market volatility remaining high we prefer diversified bond funds and increasingly those managers able to pursue more dynamic mandates.
Commodities
Having imploded towards the end of 2008, commodities have bounced back strongly since the start of the year. Although restocking and increased infrastructure spending are likely to provide continued support in the short term, we remain cautious towards commodities given the poor outlook for global growth. The investment case is further complicated by how to gain effective exposure. Resource companies continue to show only limited correlation to their underlying commodities. As profit margins are squeezed, capital expenditure is shelved and the marginal cost of production mothballs expensive projects, such as tar sands. Where the counterparty risk is acceptable this is an area we believe passive trackers, such as Exchange Traded Funds (ETFs) can add value. Within commodities an overweight to ‘softs’ (cocoa, sugar and coffee) is preferred as these are less encumbered by slowing industrial production and more likely to benefit from ongoing imbalances between supply and demand.
Property
With capital values down by 45% in real terms from their peak, commercial property remains weak and over supplied. As a result the market is forecasting a further 10% decline in capital values and 12% in rental incomes by the middle of next year before a period of flat-lining. However, with the yield gap over index-linked securities at 6.5% we feel introducing some prime commercial property as a long-term hedge against inflation is a sensible idea. In the absence of any immediate inflation current yields are attractive versus both equities and bonds and demand from overseas investors has been bolstered by a 25% decline in sterling from its peak. It would be naive not to foresee further volatility but at these levels we believe investors can weather this and still receive decent returns.
We are cautiously optimistic!