Monthly Investment Strategy Update - February 2010

• China is overtaking the US as the driver of global growth.
  The US economy, traditionally the driver of global growth, appears to have transitioned from recession into recovery, although recent data has been mixed. This contrasts strongly with China, where recent statistics have exceeded market expectations. Indeed, whereas US economic activity remains significantly below pre-crisis levels, many indicators in China have surpassed their previous peaks.
• The US economy has made the transition from late recession to recovery...
  The recent stabilisation in US unemployment and slight rise in industrial capacity utilisation suggest the economy has made the transition from late recession to recovery. This confirms existing signals from our recession probability model and has important implications for asset class returns. In the second half of a recession risk assets such as equities and corporate bonds typically perform very strongly and P/E ratios rise in anticipation of recovery, as has been happening over the last ten months.
• ...a harbinger of more muted equity returns in 2010.
  Yet once recovery takes hold equity returns tend to be much lower than in the final stages of the recession. Earnings grow strongly, but returns weaken as equity markets have already anticipated and priced-in rising profits. Nevertheless equities tend to outperform government bonds, whose prices move inversely to rising yields. This is what we expect to happen over the course of 2010.
• Government bonds face a combination of cyclical pressure and fiscal-policy concerns.
  In addition to the ordinary cyclical pressures that are expected to push bond yields higher in 2010, there is also a positive correlation between bond yields and both government deficits and debt-to-GDP ratios. If politicians do not come up with more credible plans to restore public finances, markets will force them to via some combination of higher bond yields and weaker currencies.
• Index-linked and corporate bonds look set to outperform government debt.
  In this environment we continue to favour index-linked over conventional government bonds. Index-linked bonds offer protection against the temptation for governments to use inflation as a covert way of defaulting on their debt. We also favour credit over government bonds, due to the yield pick-up and the potential for high-grade corporate bonds to surpass government debt as the new risk-free benchmark. 
• The first signs of tightening usually trigger a correction, which proves to be a buying opportunity…
  In the near term there is a very good chance of a sell-off in equity markets. History shows that in recoveries from big secular bear markets, like the recent one, the first monetary tightening tends to trigger a big correction. The correction usually proves to be a buying opportunity, however, as it becomes clear that recovery is continuing. Past corrections tended to be triggered by the US Federal Reserve (Fed). For now the Fed continues to signal steady rates for at least another twelve months.
• …but this time the trigger is likely to be China and not the Fed.
  But the Fed is no longer the only game in town. China’s central bank has started to tighten policy by increasing bank reserve requirements, curbing bank lending and increasing rates by a token amount. The Chinese, via rapid lending growth and very aggressive fiscal stimulus, have almost single-handedly kept the global economy afloat over the past year. Chinese tightening is a significant development with potential to upset markets, and has come against the backdrop of dangerously bullish equity-market sentiment. 
  
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