By NIGEL PARSONS 02/11/2009
Discussions over the shape of the recovery have started to resemble an episode of Countdown, with Vs, Ws and Ls all put forward to explain the likely scenario. Certainly, over recent months we have seen something of a V shaped bounce, as massive fiscal and monetary stimulus has delivered rising economic indicators and better than expected corporate profits. However, having avoided the disaster scenario, what happens next? Will the nine letter word be 'recession' or 'expansion'?
Risk appetite returns
Following the turmoil of 2008, risk appetite has certainly returned and our latest asset allocation meeting comes hot on the heels of the largest ever three month rise in the FTSE-100. However, despite equities grabbing the headlines there have been equally impressive gains across other asset classes, noticeably corporate debt, where demand for higher yielding assets has pushed up capital values. The question we have been left asking ourselves is "are we at the start of a new bull market rally or are markets travelling more on hope than expectation?"
Our outlook
We believe that the economic outlook is one of slightly expansionary numbers going forward, with a weak recovery in developed economies and a more robust one in the Emerging markets. The UK consumer continues to focus on repaying debt, although this still remains at record levels, and given that credit has fuelled consumption for the last decade this will inevitably have an impact on growth. More importantly, whilst banker baiting appears to be the order of the day, unless international agreement can be reached to ensure a level playing field, the insistence of the UK authorities on tighter regulation could prove hugely counterproductive.
UK equities
Over the last 20 years, consecutive governments have been happy to reap the benefits of a growing service sector. However, our dwindling manufacturing base has seen the difference between our positive services balance and negative goods balance become progressively worse; shrinking the financial services sector in the UK will not only damage GDP growth but without a substantial manufacturing and export base will also lead to an ever increasing current account deficit. Against this backdrop, sterling is likely to continue to be under pressure and it is our long term intention to reduce exposure both to UK equities and sterling in general.
Asia still looking positive
In comparison, the superior demographics and a lower cost base lead us to believe Asia and the Emerging markets remain attractive over the long term. However, we are still some way off seeing sufficient spending power in the burgeoning middle classes to fully counter the slowdown in exports from these regions and given the recent rise we have seen in valuations we will be increasing exposure on the dips.
Asset allocation changes
Following our last asset allocation meeting we highlighted the importance of the output gap, arguing that for as long as unemployment remains stubbornly high and infrastructure underutilised, inflation will remain subdued. This view now appears to be gaining consensus and as a result whilst the income yields on corporate bonds are still attractive, much of the capital value has now been realised. We are therefore reducing our bond exposure in favour of commercial property and hedge funds, where returns look more attractive.
Commercial property
After two years of falling capital values, commercial property prices have started to stablise and with yields of over 6% available on prime property total returns are now improving. On a cautionary note, whilst we are happy to increase exposure, in part as a hedge against inflation, it will only take a small knock in confidence to reverse the positive sentiment that has built up. In addition, we should not lose sight of the fact that property is an income, not a capital asset and that over the long-term, rental growth remains the fundamental driver of capital values. In the current economic climate, upward only rent reviews are still some way off being enforced and we are not anticipating significant capital appreciation in the near term.
Summary
In summary, recent market movements reflect both a renewed appetite for risk, underpinned by near zero interest rates, as well as a fundamentals rally driven by cost cutting. However, just as central banks now have one eye on their exit strategies, so must we. 2010 is likely to see central authorities remove the stablisers, forcing economies to stand on their own two feet; whilst at a corporate level cost cutting cannot continue indefinitely. Final demand remains weak and high levels of debt are likely to ensure a low growth world for some time to come. Notwithstanding this, opportunities will exist and with more people employed in our research department than ever before, we remain ideally placed to exploit these opportunities. Our nine letter word is 'dexterous.'