Autumnwatch
Quarter 3 2009 review
The strong recovery in stock markets gained
further momentum in the third quarter fuelled by
better-than-expected corporate earnings, a raft of improving
economic indicators across the globe and an increased appetite from
investors to hold 'risk' assets, rather than sit in near
zero-yielding cash deposits. Global equities, measured by the MSCI
World Index, rose by just under 17% during the quarter. The FTSE
100 returned 21%, making it the best performing quarter for UK
'blue chip' companies since the index began in 1984. Further
afield, there were spectacular performances, once again, by the
Brazilian, Russian and Indian bourses, with each delivering returns
of 26.7%, 27.1% and 18.2% during the three months ending September.
Robust returns were not limited to equity markets and investors
have captured uplifts whether they have allocated capital to
government bonds, corporate bonds, commodities, hedge funds or
property. The heady cocktail of extraordinary liquidity coupled
with a co-ordinated commitment from policy-makers to maintain this
accommodative stance has been the catalyst for one of the most
powerful rallies in risk assets in recent market history.
Many of the trends that were developing in the
second quarter have continued to hold true over this last reporting
period. Growth forecasts have been upgraded for the second half of
the year and the prospects for 2010 have improved markedly as a
degree of economic visibility has emerged. Household savings rates
across the Western economies have risen as consumers and banks
deleverage, and this has supported the view that global imbalances
will, albeit slowly, reverse. The emerging world consumer is
growing in economic importance and investors are fast recognising
the opportunity that well-placed international consumer goods'
producers, healthcare and IT companies now find themselves in. It
seems even the much-maligned car industry has a chance to survive
when auto sales in China are up 90% year-on-year to the end of
August!
This mood of a return to global economic
prosperity permeating capital markets owes much to the actions
taken by governments and their officials since the collapse of
Lehman Brothers in September 2008. Proactive fiscal policy
and loose monetary policy have stabilised both developed and
developing economies, and innovative measures to stimulate
household and corporate demand have undoubtedly fostered rising
confidence. Recent remarks from the managing director of the
International Monetary Fund (IMF) urging policy makers to 'err on
the side of caution as they decide to exit their crisis response
policies' highlights the desire to ensure the economic progress
made to date is not put at risk by premature policy action. Indeed,
for many, preparing for the consequences of future
government responses is now more important than
the financial crisis itself. As wealth managers,
we share this view and see it as perhaps the biggest influence on
the direction and sustainability of any economic recovery.
Our last quarterly report referred to the
bar-bell approach we had introduced to portfolio construction - a
process that purposely overweights allocations to assets at the
low-risk end of the risk spectrum and, in turn, allows us to make
smaller, targeted allocations to high-risk assets.
We have maintained this approach through the
quarter, content that our tactical asset allocations made in the
early summer would capture gains for our clients, but secure in the
knowledge any sudden deterioration in sentiment or negative news
flow would not unduly hurt portfolio valuations. In terms of
high-risk assets, the capital we committed to Greater China, India,
Hong Kong, Australia, South Korea and Singapore either directly, or
via our pan-Asia funds, has delivered attractive returns as all
these markets have risen between 10% and 25% over the quarter. We
have held an exposure to Brazil throughout the year and our
portfolios have benefited from the 97% growth the MSCI Brazil (US$)
index has delivered for the nine months ending 30 September. This
performance has been a catalyst for us to take profits towards the
end of this quarter, however, we believe the economic fundamentals
remain very strong for Brazil and we have maintained exposures at
reduced levels.
At the lower-risk end of the spectrum,
investment grade corporate bonds have continued to benefit from the
huge inflows of investor capital, with the UK corporate bond market
posting its sixth consecutive month of positive returns in
September. Given the reluctance of banks to lend, the corporate
sector has been able to 'tap' this demand from investors and a
flood of new issuance has characterised the quarter. This
opportunity to bypass the banking sector is likely to continue and
the ease with which companies have been able to refinance via the
capital markets has been a significant contributor to restoring
confidence across all asset classes.
Despite the headlines supporting the rise in
developed nation's equity markets, we have retained the view
markets are discounting too-robust a recovery and the sectoral
shift to cyclical stocks has left some of the un-loved sectors,
such as utilities, undervalued and therefore cheap. Towards the end
of this quarter we have been ensuring all portfolios have
allocations to both water and power-generating utilities. The
benefits of this are two-fold; firstly these companies tend to
support healthy dividend flows which are attractive in this
low-yielding environment and secondly, the revenues of a number of
utility companies rise in line with inflation due to price
regulation controls. The timeline for any inflationary pulse, at
present, seems quite lengthy although this asset allocation helps
to part hedge portfolios to this risk ahead of the curve. For this
same reason, we have increased exposure to physical gold to a
minimum of 5% across all our discretionary
portfolios.
Looking ahead
In our view, the so-called 'relief rally',
which began in March of this year and has continued apace ever
since, has run too far and too fast, ignoring some very fundamental
headwinds. We believe these will ultimately temper expectations and
call for a revision of current valuations. We monitor and assess
numerous data series and factors as we shape our views and this
process has consistently distilled the following five
issues:
1. A weak banking sector - the banking sector
in the developed world remains weakened by the financial
crisis and asset quality is deteriorating as the household and
corporate sectors struggle to service debt. The IMF recently
published their Global Financial Stability Report and while they
commented the state of the real economy was improving, banks
'remain under strain' and they restated their view the global
banking sector losses would still reach US$2.8 trillion. For the
first half of 2009, circa US$1.3 trillion of write-downs have been
reported suggesting we are only half way through the necessary
unwind. In other words, if the IMF is correct, significant
write-offs still remain to be taken within the banking system.
Additionally, banks are already considered under
capitalised in the light of pending regulatory reform and
this will limit their ability, and appetite, to lend. The flow of
credit through economies will continue to be restricted and
this does not augur well for a robust, sustainable economic
recovery.
2. Consumer deleveraging - the over
indebtedness of the Western consumer is well documented. We know
savings rates are rising; however, household balance sheet repair
has only just started and will take a number of years to correct.
Data from the Federal Reserve showed that consumer credit declined
by $21.6bn in July, or 0.9%, the biggest drop in percentage terms
since 1975 and more than double analysts' expectations. Unless
consumer spending can pick up the baton from the current rebound in
economic activity, prospects for both Western economies and
their equity markets must be muted. With unemployment set to
continue to rise through 2010, we think consumer demand will be
weaker than markets have priced in.
3. Corporate capital expenditure cuts - a
recent survey in the US revealed that 79% of CEOs questioned expect
capital expenditure to be flat or down over the next six months.
Management teams are not confident about the strength of the
recovery (see consumer demand above) and top-line sales growth is
difficult to capture. This is endorsed by the fact that the
majority of the released second quarter 'better-than-expected
corporate earnings figures' had a high reliance on one-off cost
savings, rather than growth in repeatable revenue earnings.
4. Public sector weakness - the
governments of the Western world have amassed enormous debts as a
price for the substantial stimulus packages introduced. GDP
growth this year has been almost exclusively derived from public
sector spending. This must, however, be cut and, given the
weakness of the private sector, this will be a very strong
headwind against economic recovery. Logic would dictate
that public spending must be curtailed and taxes raised, draining
consumer-spending power still further.
5. Policy risks - the IMF believes it is too
early to withdraw official support policies, but a strategy for
disengagement is needed. As speculation grows to when policy
changes will be announced, we are almost certainly likely to see
higher bond and currency volatility, rising bond yields, and
inflation concerns grow. The likelihood of perfectly timing the
reversal of this unprecedented support is remote and confidence in
the economic recovery will be very vulnerable to ill-judged policy
mistakes.
Conclusion
In the midst of this ongoing surge in asset
prices, we feel it is important to take a step back from the daily
noise that is commonplace in the investment management industry.
While we would not deny that the worst is over and Armageddon has
been avoided, we would argue that the above five issues indicate we
are a long way off a full recovery.