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Monthly Investment Strategy Update July 2010

• Aggressive fiscal tightening intensifies the headwinds impeding global recovery.
  
  At the start of the year our central scenario for 2010 and 2011 saw three major headwinds impeding global recovery: fiscal tightening, households rebuilding savings and banks shrinking balance sheets. With governments running scared of bond markets, fiscal tightening is now being aggressively pursued in the euro-zone and the UK. This heightens the key risk to our central scenario – that intensifying headwinds overpower the fledgling private-sector recovery, leading to deflation. Central banks will therefore keep ultra-low rates in place for longer than generally anticipated and stand ready to intervene swiftly with a further injection of quantitative easing.
  
• The UK emergency Budget improves the outlook for gilts and sterling.
  
  The UK Budget will come to be seen as a watershed event for the economy, sterling and the gilt market. It materially reduces the risk that gilts get downgraded and takes pressure off sterling against the euro and dollar. The euro looks overvalued against sterling and now that the UK has a fiscal plan, markets will increasingly focus on the US government’s deficit. The US will need to come up with a credible consolidation plan after November mid-term elections, or be forced to by the bond markets. Part of the US solution is likely to be currency weakness, a tempting option for all indebted developed economies that will boost gold as the ultimate liquid store of value.
  
• Fiscal tightening to unleash deflationary forces, helping keep rates close to zero for longer.
  
  Fiscal tightening takes demand out of the economy and is a deflationary process. It will pretty much wipe out growth in the euro-zone as a whole and take a major chunk out of UK growth, reducing the need for inflation hedges like index-linked bonds and commodities. To offset the drag on growth US, UK and European central banks will need to keep interest rates close to zero for much longer than previously expected and ramp up quantitative easing. In such a low-rate environment corporate bonds, commercial property and high-yielding equities should be held to enhance yield.


• Ultra-low rates in the developed world will put pressure on emerging currencies to appreciate.
  
  An extended period of ultra loose monetary policy in the advanced economies will put pressure on Asian and emerging-market economies to allow their dollar-linked currencies to appreciate, as China recently did. Consequently, currency appreciation is likely to be an important part of emerging-market returns for dollar, sterling and euro-based investors.


• A more-pronounced slowdown in global growth and earnings than expected.
  
  Another central tenet of our 2010 outlook was a slowdown in global growth in the second half of 2010 and in 2011, amid the difficult transition from stimulus-driven momentum to self-sustained growth fuelled by the private sector. Consensus US growth estimates have begun to be downgraded, but only from 3.3% this year to 3.1% in 2011. We expect the slowdown to be more pronounced, falling to somewhere in the region of 1.8- 2.3%. We also see 2011 US profit growth slowing to 10-12%, well below the 18% consensus.


• Adjusting to lower expectations will keep equities volatile.
  
  Based on current prices, this suggests an end 2011 price-to-earnings ratio (PE) for the US equity market of 12.6-12.9, compared to the current 11.7 forecast. Even at this level PEs would still be well below their long-term average of 16.8, implying room for modest further gains over the next 12 months. But returns are likely to fall well short of the near-20% seen over the past 12 months. The process of adjusting to lower expectations will keep equity markets volatile and we may yet see fresh lows for 2010.

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