Monthly Investment Strategy Update - May 2010

• Business surveys strongly suggest global recovery is gathering pace.
   
  Exceptionally robust monthly business surveys for March have provided compelling evidence that the global recovery is gathering pace. The global purchasing managers’ survey rose to a six-year high, attesting to the highly-synchronised nature of the upswing. Individual country surveys have also recovered sharply for their low points, with marked rises in the CBI survey in the UK, the Ifo survey in Germany and Belgian business confidence. Moreover, monthly trade figures show overall world trade rebounding strongly, with the most recent Asian data, IATA air freight traffic and global PMI export orders all signalling that even better news is in the pipeline.
   
• Top-line sales growth has combined with improved margins to drive robust earnings results.
   
  The improvement in the macro environment is evident in company earnings and trading statements. Profits have risen sharply since their trough in late 2008 and improvements in profit margins from cost cutting have increasingly been coupled with top-line sales growth. In first-quarter reporting so far, a net balance of 62% of US companies’ results were better than the market had been expecting and overall earnings were 23% better than forecasted. Although mainly driven by margin improvement, overall sales were also 4% better than expected.
   
• More-confident CEOs are ploughing profits into new investments and creating jobs.
   
  Improving profitability is boosting CEO confidence, which should in turn boost business investment, M&A activity and employment. There are already clear signs of a revival in US business investment and employment, which will support sustained growth in private-sector activity as monetary stimulus fades and fiscal policy turns restrictive. Consensus GDP forecasts have been steadily revised higher since last summer, when economic data first began to surprise consistently by its strength. Further upgrades to GDP forecasts are likely as the realisation grows that the economic recovery is sustainable and that the downside risks may be less pronounced than the consensus suggests.
   
• Inflation does not look like a threat to continued low interest rates in the major developed economies.
   
  Although inflation is an issue for a number of emerging market economies, core inflation measures remain well contained in the major developed economies, with core G7 inflation falling to just 1.0% in March. Although the risk of Japanese-style deflation in the US and Europe is receding, the likelihood of either actual inflation or inflationary expectations coming unanchored remains low, given the amount of spare capacity in these economies. This means that central bankers in the major economies are likely to keep official interest rates at their current abnormally low levels, helping to offset fiscal tightening.
   
• A global recovery with inflation in check favours risk assets over government bonds and cash.
   
  With the global economy in the recovery phase of the cycle and inflation being kept in check by spare capacity, we expect equities and corporate bonds to outperform government bonds in the months ahead. Commodities and commercial property are also likely to offer better returns than cash. However, equity returns are not expected to match those seen in 2009 now that valuations are closer to historic averages. Emerging and Asian equity markets could be held back in the near term by relatively expensive valuations and measures to avert an overheating, particularly in China. Still, we retain a long-term bias towards these faster-growing markets.

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