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Finding succour

The distress suffered by financial markets following the near-collapse of the world’s banking system and the realisation that the economy is unlikely to escape a painful slowdown have provided an ideal environment for government bonds. Unsurprisingly in today’s hostile climate, capital preservation and safe-haven investing remain dominant themes in asset allocation decisions, and these strategies have been responsible for a dramatic flight to safety.

As anticipated, inflationary pressures have now subsided and concerns over rising price levels in Europe and the US have been replaced with worries of deflation. Such a development would probably result in a further loosening in monetary policy of the world’s central banks, thereby enhancing returns from government bonds.

Further interest rate cuts would also boost returns from investment-grade corporate bonds, an area of the fixed-income market starting to offer good value. Once lending rates are reduced, corporate bonds will rally and we expect the credit spreads on these assets to reach their highest ever.

The next step for investors will be to try to ascertain the bottom of the equity market.

Of course, interest rates need to fall, credit spreads to narrow and company fundamentals to improve before equity markets can factor in sustained recovery. Nevertheless, global equity valuations are starting to discount a pessimistic outlook. We have therefore reduced our negative view of financials following recent falls, but only with respect to banks “too big to fail”, such as JP Morgan, Wells Fargo and Bank of America.

Amid wide stockmarket vacillation, it is up to the fund manager to know where the entry point will be, to carry on investing but keep back enough cash to take advantage of opportunities when they arise.

Our preference for US equities over their UK counterparts remains unchanged and is based on the view that sterling could lose ground against the dollar – and other foreign currencies – over the coming months. Given the difficult credit conditions, exposure to well capitalised US companies is desirable.

The US stockmarket has been heavily affected by the credit crunch but the fallout for Japan and Europe has been greater. Put simply, the defensive qualities of US equities should continue to meet investors’ need for high-quality, dependable businesses that can grow earnings steadily throughout the economic cycle.

We particularly favour US consumer goods and pharmaceutical firms, such as Colgate-Palmolive, which are benefiting from the strong structural growth in developing countries. For example, Colgate’s good earnings’ visibility, robust cashflow and good growth prospects are all supported by its exposure to rapidly expanding consumer markets in Asia.

The valuation risk associated with many Asian stocks is currently too high, so investing in the likes of Colgate can allow investors access to Asia’s economic expansion at favourable valuation levels.

At a stock level, the benefits of diversification cannot be overestimated. The reversal in fortunes of the mining and oil sectors in September served as a stark reminder to investors of the need for balance in their portfolios. Amid extreme uncertainty, we feel there are substantial gains to be achieved from holding stocks within the large caps, technology, pharmaceuticals and the “global defensives” banner. Although such exposure should be continually tested for its genuinely defensive qualities, increasing equity allocations towards these areas seems sensible.

Another theme that deserves closer attention is an unprecedented demand for agricultural products as the world’s population grows. The need for more arable land, fertilisers and pesticides from Asia, as well as the emergence of biofuels as an alternative energy source, makes the investment case for many agricultural commodity stocks.

David Jane is head of multi asset at M&G


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