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World is finding a new balance

Since our last contribution to this column at the beginning of March titled, Markets can go up as well as down, risk assets around the globe have soared. At the time, we commented that if reflationary policies undertaken by government authorities are seen as taking hold, equity markets and other risky assets would likely enjoy an explosive rally. The flip-side, of course, was that safe-haven assets like government bonds would get crushed.

Since then, the S&P 500 has risen by more than 34 per cent. This bounce, the sharpest in the post-war period, has taken only 43 trading days. Over the same period, the yield on the 10-year Treasury note has also risen materially, back to its highest level since mid-November.

Again referring back to our March commentary, we wrote of the extremely stretched technical situation within markets. The period since has seen these conditions largely reverse.

Having now retraced close to 40 per cent of the bear market that began last June, we expect equities to enter a consolidation/ corrective phase, allowing time for the fundamentals to catch up. The short-term risk, however, is that they don’t, making this phase more corrective than the market now expects.

Underpinning the rapid move higher over recent weeks has been a round of “less bad” contractionary numbers in the West, and some better than expected expansionary numbers in the East (mainly China). While promising, it remains unclear in our view whether this signals merely an inevitable improvement from the post-Lehmans’ freefall or a more sustainable turn in the business cycle.

Indeed, even if it is the latter, visibility as to how this cycle will evolve from here remains uncertain. Through its deleveraging process, the world is resetting to a new equilibrium level of demand. Debt is being drawn down and personal savings are on the rise. Banks are cutting back on lending and securit- isation of various types has seriously slowed. Home prices are dropping all over the world and unemployment is on the rise. Commercial real estate is rolling over, to which banks all over the world remain exposed.

This backdrop clouds the earnings’ picture also, where there remains substantial risk to the downside. Indeed, while around two-thirds of S&P companies have managed to beat their beaten-down earnings per share estimates during the first quarter of this year, two-thirds also missed their revenue numbers. In other words, cost-cutting remains the name of the game.

Inevitably, only time will tell whether we have seen the depths of the cycle. The market has priced this more or less as a certainty, and is decisively focused on a V-shaped recovery. Confidence will have a big bearing on whether this optimistic outcome will materialise.

Having moderated the defensive tilt to our portfolios over recent months, we are once again beginning to add back some of these positions. Considering that many defensive areas have stood still during this rally, they once more look attractive in any other scenario than a V.

Robin McDonald is fund manager at Cazenove multimanager

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