Monthly Investment Strategy Update August 2010

• Growth will disappoint as austerity across most of the global economy starts to bite.
  
  Global growth will slow by more than the consensus expects in 2011 as fiscal tightening by a large swathe of the developed countries starts to bite. The austerity measures in these countries, which account for sixty percent of developed economy GDP, will add to continued consumer de-leveraging, while banks remain reluctant to lend. Emerging markets will be affected by weaker demand in key export markets, but it is important to remember that these countries have scope to engage in further policy stimulus if required. Indeed, we expect China to ease policy later this year and provide a catalyst for outperformance by Chinese equities.


• A return to recession in the US remains a key risk, but far from a certainty.
  
  Although we expect US growth to slow, a return to recession remains a key risk rather than a certainty. The probability of a double-dip has risen in recent weeks, but remains well below fifty percent. Leading indicators suggest a 10-30% probability of a return to recession over the next six months. This even allows for the danger of a policy error as the economy makes the transition from policy stimulus and growth that is driven by inventory rebuilding to a sustained private sector recovery. Nevertheless, this transition will not be a smooth process, so equity market volatility will have regular spikes.


• Slow growth and high unemployment is typical of post-crisis recoveries, and suggests rates will stay low for longer.
  
  Just as anaemic growth is par for the course in post-financial-crisis recoveries, so is sustained high unemployment. Against that backdrop, and with simple policy rules suggesting that central bank interest rates should be minus five percent rather than zero, interest rates are likely to stay on hold through this year and next. As markets come to terms with this, government bond yields will remain under downward pressure and the yield curve will continue to flatten. The low rate environment will drive yield hungry investors into higher yielding assets like corporate bonds, commercial property and dividend-paying equities, pushing up their value.


• A second round of quantitative easing is likely, boosting emerging currencies and gold.
  
  There is also a high probability that the major central banks will engage in another round of quantitative easing. Ample spare capacity continues to push down on developed economy inflation rates, which are already getting dangerously close to outright deflation. The spectre of the US, UK and European central banks electronically printing money is likely to cause emerging economy currencies to appreciate against the major reserve currencies and drive continued demand for gold as the "ultimate" currency. With inflation more likely to fall than rise over the coming months, we expect breakeven inflation rates to fall further and continue to favour conventional government bonds over index-linked.
• The phase of recovery and valuations suggest modest equity returns, a good environment for hedge funds.
  
  Given the phase of the economic cycle and current valuations, we expect modest positive equity returns over the next twelve months. Historically hedge funds have tended to outperform equities in such an environment. The economy is early in the recovery phase of the cycle, a period when equity returns have tended to be low and driven by earnings rather than rising valuations, such as price-earnings ratios. Equities are unlikely to power ahead until the economic recovery is far more mature. Nevertheless, it is important to remember that even our below-consensus forecast for economic growth in 2011 is still consistent with positive returns from equities. We continue to favour emerging-market equities, reflecting a lack of consumer leverage, fiscal problems and dependence on bank lending compared to developed markets.

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