Road to recovery

13 November 2009 8:00 am

It has been a year of contrasting fortunes for investors. From an economic standpoint, the outlook is still very mixed. Recent talk of recovery in the UK has been partially aided by wishful thinking and not based on hard evidence.

Industrial inventories have improved but it is still unclear whether this is based on new orders or merely restocking. Unemployment has yet to peak and falling tax revenues have contributed heavily to the Government deficits. The nationalisation of sizeable parts of the banking industry has caused Government debt liabilities to increase materially.

In the rest of Europe, industrial production remains weak and sentiment indices are inconclusive as to the strength of the present recovery.

In the US, contracting consumer credit is still a concern. Record foreclosures and loan delinquencies indicate that talk of an end to quantitative easing is premature. Any small increase in confidence is likely to quickly evaporate if loan modifications are not targeted where they will have the greatest effect.

The important thing to remember here is that recovery from the problems of the last few years of excess will be a long haul. Increased money supply and quantitative easing have not led seamlessly to an improvement in the credit availability for corporations or households as Governments would have liked. Even in the Pacific Basin, where the banking crisis has not been as acute, loan growth has not increased as consumers and companies save cash rather than spend.

We expect quantitative easing to remain a key theme for 2010. The recovery, when it comes, will be about reductions in supply and not about improving demand.

Equities

In March, we had a more positive opinion of equity and risk assets than we had previously forecast and this view has been handsomely rewarded over the last two quarters. The market rally to date has almost entirely been focused on the lower-quality, cyclical stocks that had been so savagely sold down in 2008 and early 2009.

Risks still exist for certain sectors such as smaller retail banking and consumer-led cyclical industries. The continued unravelling of the retail balance sheet will limit any recovery led by improving consumer demand.

Tighter credit terms and a financial sector burdened with longer-dated debt book will put pressure on the small-cap market. But large-cap stocks providing industry leadership, low earnings’ volatility and earnings’ growth relative to their peers will offer the greatest opportunities.

For the remainder of the year and into 2010, sentiment is likely to swing between extreme pessimism and excessive optimism as investors decide on the strength of any recovery.

Equity valuations will again be placed under pressure and the safest haven will be larger- capitalised businesses, with consumer-reliant smaller businesses recovering later in the cycle. Infrastructure, transportation, alternative power and commodities will all benefit during this period, as will pharmaceutical and telecoms companies - the only two sectors where dividend yield is currently higher than bond yields.

Mergers and acquisitions are inevitable as structural change across all industries becomes apparent and these will become increasingly cross-border. Consolidation is expected to become a key issue and the recent bid by Kraft for Cadbury is a case in point.

Bonds

Our focus during 2009 was to pick up yield in corporate debt and emerging market bond assets. Again, they were the clear beneficiaries of a risk asset rally since spring 2009 as spreads to government bonds shrank aggressively. We now expect this trend to stabilise and investors will need to become more selective regarding sector picks, with risk/reward characteristics more suited to higher-quality credit versus high yield.

With large swathes of the credit sector nationalised, Government bond liabilities are understandably growing and are expected to expand further during 2010.

Loans taken by Governments or by the consumer eventually have to be repaid. In the longer term, the issues created by the increase in Government debt will become more apparent, especially as the statistics are currently not taking into account the contingent liabilities created by bank nationalisations.

Apart from cuts in public spending (which will be politically unpopular), another way of attracting money is to increase interest rates to help encourage “hot” money to be invested into an economy.

In the longer term, we expect national governments to begin raising the term structure of interest rates, in effect competitively devaluing their currencies. However, this is way out on the horizon.

In the shorter term, expect much more of the same medicine of quantitative easing and low interest rates. High-quality corporate debt and emerging market government debt have a very favourable outlook when compared, on a yield and risk basis, to developed government paper.

Commodities

A burnished beacon of opportunity remains in the commodities’ sector. The principal beneficiary of the aggressive stance taken by Government with regard to quantitative easing has been gold. China is still sucking in soft and hard commodities and the trend remains strong. This is creating investment opportunity in developed and emerging corporate markets, where developed market expertise is needed to take advantage of the distribution opportunities in this region.

To conclude, we have participated in the equity and risk asset rally of the last six months but are now wary of future exposure to lower-quality investments. There are clear beneficiaries at the early stage of a recovery, such as large-cap equities and higher-grade corporate bonds. This view is reflected in the positioning of our portfolios. We remain vigilant regarding risk factors related to government policy but are confident of the opportunities beginning to emerge.

 

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