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Promising position

Although there has been a marked increase in market volatility, the big picture of late is that there is not any discernible trend and markets are trading off each rumour and data release.

In the last month we have seen markets reacting, and at times over-reacting, to a stream of news.

Equity markets have seen a rigorous debate between value investors and those who put the emphasis on the economic cycle. Value investors, who are typically more long term in their thinking, generally take a positive view on the outlook for equities and are impressed by the undemanding valuations on which most equity markets are trading.

The economic cycle type of investors are more short term in their thinking, are worried that higher interest rates and slowing economies (well, in the US at least) will create a headwind against equities. What nobody disagrees with is that the US economy is slowing and this could provide the catalyst to reduce global economic growth from the astonishing pace we have seen over the last few years.

Our view is the economic outlook is relatively benign and the Federal Reserve will achieve a soft landing. We believe European, Japanese and Asian growth will remain relatively robust, benefiting from growing domestic demand and investment. We expect US inflation to remain above the Fed’s preferred level for a while and then to track down, with both long and short US rates peaking in the second half of this year and trending down in 2007. We would agree that corporate earnings’ growth is slowing, although we believe profits will remain on a rising trend, with corporate balance sheet strength continuing to fuel significant merger and acquisition activity.

We are more impressed by the value case than the arguments of the economic cycle investors. We believe there is a good chance that the second half of 2006 could be quite a strong period for equity markets. If we are right on our view that we are seeing is more of a mid-cycle slowdown rather than the beginning of the end, then globally we would expect the more economically sensitive sectors such as industrials and consumer cyclicals to regain market leadership at the expense of traditionally more defensive sectors such as utilities, healthcare and consumer staples.

We believe the outlook for equities for the rest of 2006 holds some promise and we think we have seen the peak in the yield of the US 10-year Government bond yield and that the least investors should expect from them over the next 12 months is the 5 per cent yield they are currently trading on.

With high-yield debt offering a spread of over 300 basis points over treasuries, against our central economic view, we would expect a reasonable return from this asset class also.

The hedge fund industry has had a difficult period since the mid-May correction as many have been caught out in the shift towards more large-cap, defensively oriented stocks and sectors. We are expecting the industry as a whole to post in July its third consecutive month of losses, albeit modest. This is an unusually long losing streak and would be the first time this has happened since late 2000. If history is a guide, we might reasonably expect returns to pick up from here.

We have above normal allocations to equities generally and non-US equities in particular. We continue to hold a position in energy, where we see further scope for stock prices to catch up with the high price of oil. Hedge funds, private equity, high yield debt and real estate are all held at what we regard as normal weights while investment-grade bonds are underweighted as we expect the other asset classes to outpace them.

Julian Sutton is senior portfolio manager of Schroeders’ multi-manager team


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