Monthly Investment Strategy Update
Signs continue to mount that the global slowdown is abating and that we are in the final phase of a long recession, not in the midst of a depression . As a result, we are increasingly confident that the global economy will bottom late this year. The OECD’s leading indicators of growth have turned up, albeit from very low levels, especially in Asia. Purchasing Managers’ Indices have risen further, led by new orders, and we expect them to rise again in the months ahead. The pace of job losses in the UK and the US shows signs of slowing. In the past, that has happened close to the low point of the cycle. This, along with stronger equity markets, has helped to stabilise consumer confidence as concerns about unemployment have started to fall from historically high levels. There is also evidence of a gradual thawing of credit markets, and fewer banks are tightening lending conditions.
…but the recovery will be restricted by several factors, particularly in developed economies. Nevertheless, the pace of developed economy growth, once the recovery starts, will be inhibited by four structural headwinds : fiscal tightening; muted growth in bank lending; consumer de-leveraging; and greater regulation and state planning of the economy. Capital injections and balance-sheet cleansing may have stabilised the financial system, but they have not provided enough capital to support strong lending growth. As a result, growth in the years ahead is likely to be tilted towards the emerging economies, which do not face the same structural headwinds, rather than the developed economies.
Inflation expectations remain low but could take off later on if QE succeeds in boosting credit growth.
Despite the improving activity data, inflation expectations have remained very stable . Investors don't see inflation as a serious threat in either the short or the long term. We forecast that inflation will fall further in the near future under the weight of excess capacity but, if credit growth finally responds to quantitative easing (QE) and accelerates, inflation expectations are likely to rise. Moreover, for politicians faced with the painful alternative medicine of cold turkey, a little more inflation would be the easy way out of the fiscal mess the financial crisis has left most developed economies in.
Policy action seems to be working on the economy, and risk appetite is returning. A stabilised banking system combined with mounting evidence that monetary and fiscal policy are starting to have an impact on the real economy are reducing financial market volatility and enabling investor risk appetite to return. Investors are starting to see value where previously they only saw downside risk – QE is doing its job . So it looks increasingly likely that March was an important low for developed equity markets and that October was an important low for Asian and emerging markets.
Equity markets look ripe for a pull-back, but the time for raising exposure is nearing. For bond-dominated portfolios, the best opportunities remain in credit markets, where spreads have further to fall, and index-linked bonds, which offer good insurance against longer term inflation concerns - particularly if politicians take the easy path and partly inflate away the fiscal mess - and a play on returning liquidity. Our roadmap for 2009 indicated that, as we got closer to 2010 and signs of economic recovery started to emerge, we would increase portfolio exposure to equity markets. The time to start that process is approaching, and we will be looking for opportunities to raise exposure in the months ahead via thematic investments. We are not starting the process immediately, because investor sentiment is currently very optimistic, suggesting an imminent pull-back in equity markets. Indeed, the structural headwinds facing growth in the years ahead mean that neither the market nor the economy can be expected to recover in a straight line.
