Reading the signs

3 June 2010

Even the most seasoned investors are finding the current markets difficult to read. On the one hand, many of the key fundamentals look encouraging: the global recovery remains on track, company profits are bouncing back, equity valuations are undemanding and key interest rates are likely to stay low for a good while yet.

In particular, the rebound in the US has been stronger than expected. This was initially driven by the industrial sector but recently there has been a broadening of the recovery into business capital spending and - surprisingly - the consumer. As companies have started to hire again, US consumer confidence has bounced back. These are all essential ingredients of a good market.

On the other hand, national debt levels are too high and painful adjustments need to be made in many countries. The impact of this deleveraging will inevitably restrain growth in much of the Western world, as well as potentially lead to industrial and social unrest. Of course, e have already seen unrest in Greece.

As government budget deficits rise to the highest levels experienced during peacetime, markets have begun to question the sustainability of fiscal support. The eurozone has come under acute pressure, prompting the European Union to announce a €750bn rescue package. The European Central Bank has also agreed to buy Government bonds and increase liquidity to the banking sector.

The package has been successful in reducing spreads on peripheral Government bond markets, largely driven by ECB purchases. However, significant funding needs lie ahead and fiscal policy will need to tighten for several years to return debt to more sustainable levels. Essentially, the package will buy time for eurozone Governments to get their fiscal houses in order.

We do not predict the end of the single currency but believe the price will be much greater fiscal integration, a less credible ECB and a weak euro.

The new UK Chancellor has wasted no time in announcing £5.7bn of public sector cuts, with more to follow in the forthcoming emergency Budget.

Another concern focuses on China, where there are signs the economy is overheating. Robust gains in output coupled with a surge in money growth has led to fears of a bubble in real estate and a sharp pick-up in consumer price inflation. Having suffered less during the downturn, China is ahead of the US in the economic cycle and needs to tighten policy to control inflation. More generally, while the medium-term prospects remain favourable, a period of policy tightening and slower growth may lie ahead for the emerging markets.

For these reasons, higher-than-normal volatility will remain a feature of financial markets for the foreseeable future. However, despite the problems in Europe, we have upgraded our expectations of global growth led by revisions to the US, Japan and emerging markets. Even so, we believe equities, corporate bonds and commercial property have the potential to deliver good returns - especially relative to the derisory rates offered on cash - for those willing to be patient and brave and look past current uncertainties.

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