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Schroders multi-manager view – The worst is behind us

Market sentiment clearly has improved dramatically since the first part of this year, along with growing evidence that the worst of the recession is now behind us. Whilst the hard evidence to date has only served to prove that the rate of deterioration is slowing, it is irrefutable that economic prospects look vastly better than they did just a few short months ago. As a result, not too many analysts and economists are talking about depression anymore, which is progress in itself.

Whilst there are still plenty of things to worry about, we continue to favour equities and corporate bonds for three key reasons. Firstly, even with the recent moves, absolute valuations remain quite supportive. Secondly, many asset allocators have missed much of the recent bounce, and with lots of cash still sitting on the sidelines, forced buying is clearly evident. Thirdly, along with the improvement in the economic outlook, the credit and money markets have properly reopened and companies are getting access to the capital markets in a way that was not possible in the second half of 2008.

Some would argue that equity markets have rallied too strongly since their lows in early March. Indeed, it may very well be the case that some kind of period of consolidation is in order. Who knows? To balance this though, it is worth bearing in mind that most major developed equity markets are not much higher than the very distressed levels that they started the year at.

Turning to bond markets, like many others, we continue to prefer corporate bonds over gilts, primarily because of the extra yield they offer. Again, the recent rally has led to a reduction in these yields as bond prices have risen, but even taking that into account, spreads still remain more than adequate to compensate for the extra risk of corporate credit relative to gilts. In our opinion, the biggest risk to the corporate bond story is that spreads tighten because gilt yields rise, as opposed to corporate bond yields falling. Therefore, our strategy has been to mitigate this risk by shorting gilt futures against the corporate bond positions that we hold. This way, we can lock in on the best part of the story, the spread, and benefit from any further tightening, regardless of what drives it.

Mention it quietly, but we think commercial property is starting to get really quite interesting again. In our view, there are growing indications that commercial property values are close to bottoming out, and in some categories, even starting to rise. For sure, rental growth, patches of oversupply, tenant bankruptcies and tight credit conditions will remain headwinds, but even so, after a fall of 44 per cent from its 2007 summer peak, we think that it is not too much to hope that the UK commercial property market will bottom quite soon.

The prospects of tighter Government spending, higher taxes and continued deleveraging mean that, at best, any economic recovery will surely be anaemic. Nevertheless, we are encouraged by the fact that the environment for companies has at least become more stable. As a result, we believe corporate earnings will bottom in 2009, and, with lower running costs, less write-offs and diminishing restructuring charges, 2010 will show a marked improvement. It would be too much to expect much sales growth, or indeed, any demonstration of pricing power, but even so, we think this will be far from a profitless recovery.

Andrew Yeadon is head of multi-manager at Schroders


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