On the rebound

26 November 2009

The outlook for global markets continues to brighten, much to the chagrin of those who insist the storm clouds are about to burst.

Many are unwilling to believe that market equilibrium - to a greater or lesser degree - could have been reached in such a short timeframe.

Macroeconomic data has mostly been pointing towards recovery and growth, and on a far broader scale than previously expected. Purchasing managers’ index data in the US pointed to a significant rebound in manufacturing. Composite PMI data for the eurozone rose ahead of expectations but the improvement was marginal and somewhat disappointing relative to its global counterparts. In the UK, PMI services data rose at the fastest pace witnessed in more than two years.

It is difficult to imagine the UK economy not returning to growth in the fourth quarter of this year or the first quarter of 2010. The collapse in corporate profitability is close to an end, according to the British Chamber of Commerce. Corporate newsflow continues to provide investors with sustenance and top-line growth has been visible in the past couple of months in some sectors. It is fair to argue that con-ditions are ripe for a pick-up in corporate spending in 2010, both in terms of capital expenditure and corporate re-hiring.

We still feel that, in the longer term, policy rather than corporate activity will carry the greater weight for markets. Governments have been keen to provide reassurance that policy measures will remain accommodative for as long as it takes. If the recovery continues to strengthen, however, G7 central banks can be expected to start raising interest rates. This would prove unsettling for equities and particularly damaging for government bonds and investment-grade credit. There remains the possibility of the first meaningful setback, for equity markets and bond markets, taking place in the first half of next year.

The outlook for 2010 remains skewed to the upside but with sizeable uncertainties that could have a considerable impact on returns in the near term. We have been taking the opportunity to rebalance our portfolios a touch, increasing our equities exposure on the down days, adding to our short position on government bonds and reducing our currency risk on the view that sterling could strengthen in the short term. We have been reducing our exposure to corporate bonds and reallocated capital into strategic bond funds, which have the added flexibility of taking additional risk via the high-yield bond market without adding duration.

One of the biggest questions next year will centre on asset allocation. In 2008, diversification was, by and large, a failure, with only a few asset classes (cash, gilts and overseas bonds) managing to deliver positive returns. In 2009, UK and overseas equities and investment-grade credit have been the asset classes of choice while government bonds have delivered a negative return. This year has been all about steadying the ship and steering a course away from self-destruction. The likelihood is that 2010 will see economic volatility that is likely to keep everyone on their toes. The need for sound asset allocation decisions has rarely been greater.

Bill McQuaker is head of multi-manager at Henderson New Star

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