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Down but not out

Investor pessimism over the performance of equity markets is at its highest level for the past decade, according to a Merrill Lynch survey of global fund managers in June. Negative sentiment towards equities is higher than at any time between March 2000 and March 2003 when the decline in global stocks was steeper. It is likely that the second half of this year will be challenging but there are grounds for that thinking there will be selective opportunities to make healthy returns.

US economic data has undoubtedly been weak but the latest figures suggest that the economy had not fallen into recession by the half year. It is interesting to note that US leading indicators were rising over the spring, despite the continued headwinds of higher fuel and food prices and a depressed housing market. The Conference Board’s index of economic indicators inched up for two consecutive months, registering rises of 0.1 per cent in April and May. The index is designed to forecast economic activity in the next three to six months and is based on 10 components including share prices, building permits and unemployment benefits. It is possible that while the US led the economic slowdown, it will also be among the first to recover.

By contrast, UK consumers are facing challenges such as high debts and falling house prices which show no signs of recovery in the short term. However, the Bank of England is in a quandary, with inflationary pressures leaving little room for rate cuts to restore economic growth.

Inflation is a common theme across the globe. It may prove to be less of a concern than most anticipate but central banks must take a tough stance to manage inflationary expectations. That said, interest rates in the US and emerging markets were accommodative at the half year and stockmarket valuations globally were relatively attractive.

In such circumstances, there could be improved equity market returns over the second half of the year although it seemed possible at the end of June that the lows of March would be retested first.

In the UK, market leadership is expected to remain narrow, with energy, materials and industrial stocks, especially those related to infrastructure, remaining at the top of the performance tables. Better opportunities are likely to be found beyond the UK, with emerging markets such as Brazil continuing to offer strong potential.

The worst of the credit crisis appeared to be over by the half year but the financial sector still has to undergo a prolonged deleveraging before it can return to health. This will mean the unravelling of many years of leveraging activity which has accelerated to unsustainable levels over the past decade. There are also a number of second-round effects from the sub-prime crisis that have yet to be fully felt, including house repossessions and credit default losses. The financial sector does have some merits on a valuation basis but it may make sense to avoid those funds that hold mortgage banks in countries that are in the early stages of the housing downturn, such as the UK, while favouring banks that have performed well. Firms such as JP Morgan and Goldman Sachs, for example, appear to be weathering the storm particularly well.

It may be too early to make a contrarian call on financial stocks but catalysts for future performance are emerging. Clive Cowdery’s attempted proposal to inject capital into Bradford & Bingley and turn the bank into a consolidator demonstrates a way of profiting from present adversity. As ever in investment management, volatility can be as much a friend as a foe.

Mark Harris is head of the fund of funds team at New Star Asset Management

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