Monthly Investment Strategy Update - November 2009
Growth has returned to the global economy, but will fall short of pre-crisis levels for some time.
The global economy is expanding once again, led by Asia and emerging markets. But the pace of recovery is slow and activity remains far below pre-crisis levels. Over the next few years, household and financial sector de-leveraging will exert considerable downward pressure on developed economy activity. Consequently, the pace of growth will not return to the rates experienced before the recession.
Risks are waning, but policy action and banks' health still have the power to de-rail the recovery.
Downside risks to growth are receding gradually, but remain a concern. The main short term risk is that the recovery stalls and deflationary forces become entrenched, either because of a premature exit from very accommodative monetary and fiscal policies, or as further bank write-downs cause credit conditions to deteriorate further.
Risk assets are in the ascendant in this phase of the cycle...
With activity recovering and enough excess capacity to rule out imminent rate rises, we are in the phase of the cycle which tends to favour risk assets. Equities and corporate bonds tend to outperform government bonds, and emerging market equities usually lead developed markets. This is also a time when, typically, oil outperforms cash and, as the recovery gains strength, so does UK commercial property.
…suggesting equities will continue to advance - but gains will be checked by rising valuations.
It is unlikely that equity markets will continue to rise anywhere near as quickly as they have done over the past six months. As tends to happen at this stage of the cycle, PEs have risen sharply, as markets have rallied in anticipation of an earnings recovery. However, even though the equity-to-bond-yield ratio has also deteriorated, equities look fairly valued compared with government bonds. So, on balance, valuation does not represent a significant obstacle to further equity outperformance. Yet gains will be harder won and now need to be driven by positive earnings surprises rather than by re-rating. We still favour Pacific ex Japan and emerging equity markets, as they don’t face the same headwinds to growth as Western economies: consumer de-leveraging; credit constraints; and the need to rebuild public finances. However, their recent outperformance means that they are expensive.
Corporate and index-linked bond returns should outstrip those of conventional government bonds.
Within the bond asset class, we continue to favour corporate bonds and index-linked government bonds. Although no longer priced for a severe depression and despite recent strong advances, corporate bond spreads offer an attractive yield pick-up over historically-low government bond yields. Linkers offer insurance against long-term inflation risk from quantitative easing (QE) and large budget deficits
UK commercial property appears attractively valued...
Valuation and momentum argue in favour of UK commercial property. At 8%, the yield on UK commercial property is attractive relative to yields on cash and government bonds. The momentum of commercial property is persistent, so its outperformance in August and September is a significant development. However, a lack of credit growth means that progress will be slow, and it's unlikely that another bubble is imminent.
…while commodities also remain in favour.
A weak dollar and a global recovery led by Asian and emerging economies are buoying commodity prices. Dollar weakness, because of concerns about the potential inflationary impact of QE and large budget deficits, is also supportive.
