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Simon Mungall: Don’t follow the crowd

In a recovery phase investors typically favour stocks that were the least impacted by the fallout. After the long-term capital management crisis in 1998, for example, investors flocked to technology stocks. With hope returning to the market after the latest crisis, the rally to date has centred on emerging markets and commodities stocks.

Somewhat ironically, this process often sews the seed of the next stock market bubble. It is therefore important to ensure that you are not falling into a momentum trap by following the crowd.    

Money should continue to return to global equity markets over the coming months and the rally should broaden as risk appetite recovers. At Ignis Multimanager, we have been exploring contrarian ways to benefit from recovery. Allocation has been increased to funds that are managed by stock pickers who we feel can generate good returns in spite of a weak economic outlook, particularly from developed markets such as the US and Japan, which remain under-appreciated by the wider investment community.

The outlook for developed markets is by no means rosy but sentiment had reached levels of such extreme pessimism that there is significant scope for positive surprise. In particular, the market appears to be underestimating the ability of the developed world to pull itself out of the current malaise. There is an excess demand for US citizenship, for example, so the country will continue to attract young, talented and hard working people to boost its economic potential. It also has the space to accommodate them. While growth in the country may remain anaemic, fourth quarter gross domestic product growth in 2008 was so weak that year-on-year figures for this quarter can only look good. Meanwhile the country’s current account deficit has shrunk dramatically and saving rates are returning to acceptable levels.

The main risk is that developed markets tighten monetary policy too soon. Central banks will be under increasing pressure to raise interest rates, with inflation expected to rise as the base effects of low commodity prices begin to emerge. This is an important time for the short-term outlook but we expect central banks to err on the side of higher inflation rather than rate rises. Indeed a statement from the US Federal Reserve Open Monetary Committee earlier this month said it would keep interest rates low for an “extended period”, which many believe suggests at least six months. In the meantime, there will still be scope to generate healthy returns.

In contrast, investors appear too blasé about the risks in emerging markets. China, the engine of emerging markets growth, is a command economy and does not have the necessary political and social flexibility to support this growth. Japan is perhaps better placed to support the Asian growth story and is certainly under-appreciated for its ability to do so. It has fundamentally solid, world-class companies that are well suited to the current economic environment, having survived in challenging domestic conditions for many years. Its economy should also benefit from a generation of people who have begun to retire because many held assets offshore that they are now bringing home to spend. The Japanese equity market has yet to bounce back from the lows of last year, in line with other developed markets. Having fallen approximately 50 per cent from its 2007 highs, it is difficult to see where the marginal seller is but, if we are wrong, then the downside is small based on such low valuations.     

In the current environment, fundamentals are more important than ever. Successful stock pickers will be those who correctly reassess the ability of companies to deliver on those fundamentals, regardless of market momentum.

Simon Mungall is head of multi-manager at Ignis Asset Management.

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