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Generating game

Earnings projections are too optimistic and investors need to focus on strong income generation

The economic outlook has continued to improve, with growth projections being raised for many countries. The good news is that the private sector is displaying signs of resilience, with continued loose economic policies and strong corporate profitability translating into real economic activity in many countries.

However, there are still considerable challenges ahead for the developed world and the emerging world. These challenges include monetary tightening in emerging economies, banking regulation and the resultant loanbook deleveraging, the euro debt crisis, fiscal austerity in many developed countries, cont-inued threats of a renewed downturn in real estate and, increasingly, the adverse impact on growth caused by rising commodity prices.

The economic backdrop for equity markets continues to be generally supportive of expansion, with global growth momentum improving, interest rates likely to remain low for a prolonged period and plentiful liquidity.

The main concerns surround the margins and future of corporate earnings.

Margins may well come under pressure in the coming quarters as input costs such as wages and, in particular, commodities increase.

As always, consensus earnings projections are far too optimistic and disapp-ointment will have a negative impact on sentiment.

Under such circumstances, it is important for investors to focus increasingly on well diversified, strong income-generating entities.

Government bond yields rose in the latter part of 2010 and the start of this year across the major developed markets as markets began to factor in stronger economic recovery and the reversal of the low interest rate policy.

However, yields have started to abate as economic headwinds slowed down the rate of expansion in economic activity.

As the global benchmark, US treasuries will continue to be in the spotlight. The Fed’s QE2 programme will come to an end in June which will in theory leave a massive funding demand gap that will need to be filled by the private sector.

There is a great deal of concern that yields will need to rise dramatically to entice foreign and domestic private investors. Of course, if yields were to rise sharply, it will further undermine real estate and the broader economy. As a result, the interest rate sensitivity of fixed-income portfolios will have to be managed actively.

There are still attractive opportunities ahead in the corporate bond sector. There has been a marked improvement in the financial health of the corporate sector over the past 24 months which is in stark contrast to governments’ balance sheets.

Debt ratios have been reduced through significant refinancing, cost reductions and increases in free cashflow and all this has been aided by record low interest rates.

Default rates are at historic lows and the outlook remains positive for many quarters ahead both for investmentgrade and higher-yielding bonds.

Economic prospects have improved but significant challenges lie ahead, partic-ularly rising public debt levels that could eventually lead to restructuring of government debt in Europe or even default, a realignment in the banking industry, consumers and companies adapting to the new tougher credit environment and the prospect of a gradual removal of the extraordinary period of low interest rates.

These are some of the issues that we will have to continue to monitor and will continue to shape our asset allocation.

Our focus on incomegenerating asset classes coupled with capital growth opportunities will remain of paramount importance. In addition, we will continue to actively use risk manage-ment tools. This is critical in the new global economic and financial landscape.

Neil Michael is executive director of investment strategies at London & Capital

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