Monthly Investment Strategy Update - October 2010

• Talk of double dips is not unusual early on in economic recoveries, but is likely to prove unfounded this time, with only a 30% chance growth turns negative.
  
  In every recovery since the double dip of the early 1980s, there has been a flood of stories about a second leg to the recession early on in the rebound. August saw just such a surge as US activity data turned out weaker than the consensus had expected. Our recession probability models suggest that a double dip is a possibility, but not a certainty. We believe there is around a 30 per cent chance of a double dip in the US economy, even allowing for the de-leveraging process holding back credit creation. As a result of double-dip fears, consensus expectations for 2011 US GDP growth fell sharply over the summer, from 3.1% to 2.4%, and are now much closer to our own range estimate of 1.8-2.3%.


• Yet developed-economy growth will be insufficient to head off deflationary forces, suggesting recourse to further QE in the US and the UK - a boon for gold.
  
  The most likely outcome for the major developed economies is a sustained but muted recovery as growth is hampered by fiscal tightening, consumer de-leveraging and a lack of lending growth. Anything other than a robust recovery is unlikely to be sufficient to stop inflation - already dangerously close to becoming negative - from falling further. The Federal Reserve and the Bank of England are increasingly concerned about the possibility of outright deflation and, as a result, are likely to engage in further quantitative easing (QE) during the coming months. As anticipated, gold is proving to be a key beneficiary of the increasing likelihood of further QE and the weakening of reserve currencies as investors fret that currency weakness will be needed to offset some of the pain of fiscal tightening. Asian and emerging market currencies are benefiting from these trends. Consequently, potential for currency gains is one of the drivers of our positive view on both emerging market debt and equities.


• With policy rates low for longer, yield is being avidly sought by investors.
  
  The combination of a weak recovery, ample spare capacity and low inflation will keep policy rates, and hence returns on cash, low for the foreseeable future. As investors come to realise this, yield will become highly prized in developed markets. Low cash rates will continue to drive up the value of higher-yielding assets, such as corporate bonds, commercial property, high dividend paying equities and even government bonds, where investors should remain long duration.
  
• Speculation about 'bubble' territory for bonds seems misguided, given the current backdrop. 
  
  Bond yields have fallen sharply over the past few months, leading some commentators to argue that bonds are now in a ‘bubble’. While government bonds looked overbought on a technical basis in late August, they don’t appear to be in ‘bubble’ territory. Low bond yields are correctly reflecting the risks of deflation, weak growth and low policy rates for a long time – themes that are likely to persist for the foreseeable future.
  
• Lacklustre returns from developed equity markets contrast with a more spirited performance from emerging markets, and this trend should continue.
  
  Developed equity markets have been range bound so far in 2010 and have posted only small gains. Low but positive returns driven by earnings growth rather than leverage and multiple expansion are the norm early in an economic recovery. Consensus 2011 earnings expectations have come down and look much more realistic than they did at the start of the summer, but they remain higher than our growth forecasts suggest they should be. As we predicted, emerging market equities have outperformed so far this year. This is a trend that we expect to continue as more investors come to realise that if they choose to hunt for growth, these are the markets to pursue.Both macro-economic and earnings volatility has fallen in emerging markets. Consequently, these markets are in the process of re-pricing to trade at a valuation premium to developed markets.

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