Yet again the spectre of sovereign debt default has been haunting markets, with troubles in peripheral Europe radiating out to destabilise the wider European economic region and in turn the global economy.
Intervention by the European Central Bank seems to have bought some breathing room on the continent, but the problems are far from resolved. At the same time, further questions over the sustainability of the rapid growth witnessed in China have driven fears that asset bubbles may be reforming.
That said, it hasn’t all been bad news, and solid corporate earnings continue to show the economic recovery is continuing, at least for the moment. While the global consumer still appears a little timid, corporate spending is back in full swing, enjoying the benefits of earlier painful cost-cutting and deleveraging.
Bears versus bulls
Overall, the bears seem to have been dominating the bulls over the quarter, with European equities and high yield credit looking like the most serious casualties as investors pile in to perceived ‘safe’ assets such as gold and government bonds.
These are just the extreme cases, and there has been quite significant divergence in performance between asset classes and geographies, which are detailed further in the sections below.
We believe recent weakness in the markets presents a good entry point to invest in attractively valued areas that were overlooked in the cyclical rally. With markets now diverging quite significantly in terms of recent performance and outlook, asset allocation is a key consideration for investors.
UK
Investors had plenty to worry about over the quarter. Worries over political transition, sovereign debt fears in Europe, a slow-down in Chinese growth and the oil spill in the Gulf of Mexico led to a considerable correction that saw more than 15% wiped off this year’s peak at one stage.
The domestic economic outlook remains muted with domestic consumption subdued and the new government implementing tough fiscal tightening measures.
However, it is important to remember that the UK equity markets are not the same as the UK economy, and UK companies deriving earnings from overseas continue to offer good growth prospects.
For this reason, income yielding equity funds are relatively attractive, given their bias towards defensive areas and large-cap companies with multi-national operations, as well as the income return which can compensate for the absence of capital growth.
Also following the indiscriminate sell off in UK equities, we believe that from a contrarian stance there are now selective opportunities in fundamentally attractive companies who have sound business models and robust balance sheets.
United States
The US fared better than other western markets during recent turbulence. Sterling investors have also benefited from strengthening of the dollar as recent problems with the Euro reinforced its position as the global reserve currency.
However, this can be a double-edged sword, and should the dollar continue to strengthen against sterling, it could become overvalued at which point it may be prudent to consider positions where the currency risk is hedged out.
The US economy has continued to demonstrate a robust recovery. Having taken much of the pain earlier on, we believe continued growth prospects are positive for the rest of this year, although as with the rest of the developed economies, the stimulus package will have to be paid for at some point.
Sectors that we favour are technology, which is benefiting from pent-up demand following corporate cost-cutting, and healthcare, which is benefiting both from domestic healthcare reform as well as increasing demand from developing countries.
We also believe there is a strong case for the ‘Nifty- fifty’ style of investing that focuses on companies that can deliver superior growth because of their high geographic exposure to faster growing areas of the world, the industry in which they are operating, or because of their superior technology.
Continental Europe
Europe has been a focal point for market instability over the period as concerns over sovereign debt in the peripheral nationals sent shockwaves around the world.
The central bank-led bail-out helped stabilise markets, but the stringent austerity measures needed by the economies of Portugal, Ireland, Italy, Greece and Spain to avoid default is likely to see many economies re-enter recession in 2010.
The European Central Bank bail-out has been a stay of execution, but
the dichotomy between monetary unity and political diversity is likely to give rise to periodic bouts of instability.
We believe that the European equity income sector looks vulnerable due to the banking exposure to debt securities, and with the bulk of dividends having already been paid out this year, these funds have lost their appeal.
With valuations depressed across the board, we believe this is a good opportunity for stockpicking managers who are focused on fundamental growth and who can take advantage of indiscriminate selling. Exporters, in particular, are positioned to benefit from Euro weakness.
Europe is now firmly out of favour with the investment community, which could be seen as a good entry point for contrarian investors, though sentiment may continue to deteriorate in the short-term. The historical strength of the Euro against Sterling means investors should actively consider currency risk when investing in Europe.
Japan
Despite the recent global correction, we continue to favour a tactical overweight position in Japan as we believe areas of this market are overdue a period of relative outperformance.
However, we would not favour this market as a long-term investment.
Investing in Japan is a story regarding the companies not the economy. Many companies still have global domination as well as strong trade links with China and the rest of emerging Asia.
Export sectors are likely to be the best area to focus as we continue to see the return of the global consumer, as well as further potential Yen weakening. However, it is difficult to get excited about the potential for domestic areas of the market which is under pressure due to a number of negative demographic pressures.
The strength of the currency has hurt the competitiveness of exporters and many are predicting a weakening in 2010 which would boost Japanese companies operating overseas. We therefore favour investing in a fund with hedging in place.
Asia Pacific
Continued policy tightening in China, coupled with problems in Europe, dragged equities in the region down during the second quarter, although these traditionally volatile markets held up better than many might have expected.
Although we remain structurally overweight in Asian markets based on the long-term growth dynamics in the region driven by China, there are warning signs gathering over the near term outlook for China and Chinese markets are starting to look expensive (though not quite in bubble territory yet).
As the country cuts back investment, it is unlikely that domestic consumption can compensate, leading to lower GDP growth (high single digits) which may disappoint many in the West. Given that many areas of the Chinese and other Asian economies are also very export-dependent, slowing consumption in the Western World would be a drag.
Longer-term China needs to change their economic models, from targeting output and export led growth to targeting domestic consumption led growth – however, indications are that this change is already happening.
Although we believe in the long-term growth story of China, we are now closely and actively monitoring the country to assess emerging nearer term threats.
It is all too easy to forget the wider Asia-Pacific region ex China. As China continues to be the consensus favourite, it is worth considering that growth prospects are looking perhaps even more attractive in some of the smaller and less reported about countries such as Indonesia and the Phillippines.
Emerging Markets
In the recent market turmoil, India has emerged as the most insulated thanks to its solid corporate and national governance and a domestically focused economy.
However, as with much of the rest of the BRIC markets, Indian equities are no longer looking cheap.
Latin America has been buoyed both by strong commodity demand from China and a growing domestic consumer base that is often underestimated by analysts and commentators. After a strong run, Brazil in particular risks becoming a victim of its own success as inflation and currency appreciation act as a brake on further growth.
Russia also had a strong recovery, having been hit hardest during the downturn. As a resource rich country, Russia will benefit from continued global recovery and development of emerging markets, although this prospect is looking increasingly subdued in the short-term.
The long-term outlook remains positive and we see long-term investors as under-represented in this area.
Cash
Cash returns have been paltry since base rates were slashed in Q4 2008. We expect this theme to continue through 2010 and possibly even beyond for short-term deposits. However, the yield curve is exceptionally steep and longer-term savers are being rewarded to tie up cash for 5
years, with rates up to 5%.
With the prospect of low interest rates short-term providing little return and longer term inflationary pressures meaning cash holdings are at risk of depreciating in real terms, from a risk/reward point of view the asset class remains unappealing. Liquidity and security means cash will always have a place in the majority of investment portfolios.
Fixed Interest
Market instability over European sovereign debt concerns and wobbles in the outlook for global recovery has reversed the strong risk appetite seen at the beginning of the year. This has manifested in the fixed interest space with weakening in the corporate credit markets and falling yields on gilts and US treasuries.
Interestingly we have also seen a robust performance in emerging market debt, a relatively new asset class to most UK and US investors, and an area that might typically be expected to be the first casualty of risk aversion.
Although emerging market exposure broadly is considered a higher risk offering, these countries are increasingly demonstrating fiscal responsibility and don’t have the high levels of public debt that is the case in developed economies.
In the UK, curbing fiscal spending and raising taxes means that raising interest rates is something the economy is unlikely to bear and would inevitably lead us back into recession.
Therefore we remain in the “lower for longer” camp in terms of UK interest rates.
Commercial property
Commercial property has performed well versus other risk-asset classes over the quarter, and has proven to be a good diversifier. Following re-rating of the sector last year, UK commercial property offers some interesting opportunities and the IPD benchmark currently shows attractive yields of around 7%.
In the current low interest rate environment, security of income remains a key focal point in our portfolio management and it is worth remembering that over the long term, 70% of the total return from commercial property investing comes from income.
Large, short-term flows of money into property funds has driven a level of demand that has not been matched by the supply of quality prime properties, so prices could get ahead of themselves and lead to a correction. This happened during recovery of the commercial property markets in 1970s and 1990s.
However, we remain focused on the long term-view, investing in prime property funds with good liquidity. We are happy to take an attractive yield and take advantage of diversification benefits and the fact that the asset class is traditionally a reasonable hedge in times of inflation.
