Market Watch - where to invest for 2010

The global recovery in the financial markets has continued since the start of the year but not without continuing pressures from pockets of the global economy. Concerns over sovereign debt, particularly localised crises such as in Greece, provided a headwind to European recovery and undermined the strength of the Euro. Elsewhere, the GDP growth machine of China has been going through a phase of economic policy tightening and this led to a brief correction in its markets at the beginning of the year, which also impacted a number of related markets.

Even though these incidents have been keeping the global economic recovery in check, they have not been enough to derail it and keeping the recovery on track remains in the hands of policymakers to a large extent. The high debt levels within the Western economies means that the low interest rate environment should remain with us for a while longer. However, the flip side to this, especially when combined with the stimulus actions undertaken by governments and authorities worldwide, is the prospect of higher inflation. Higher inflation will cause problems globally as it makes any potential asset price bubbles within areas such as China and other Emerging Markets difficult to control. We do not see inflation as an immediate problem for the global economy but are keeping a vigilant eye on it as it is a realistic threat further down the line.

Going forwards we see investors continuing to sell down cyclical, economically correlated stocks and seeking quality, defensive areas of the equity markets, particularly overseas markets and those that are providing a yield. Similarly, we can see bonds with attractive yields being favoured by investors keen to maintain their level of income. Furthermore, despite some short-term concerns regarding asset and valuation bubbles, we still favour increasing exposure to emerging markets both in terms of equities and sovereign debt, over the medium to long-term.

Equities

Following a negative period over January equity markets have recovered and most are in positive territory year to date. Going forward we don’t believe that we will see the same strong gains across the board that we have experienced over the last 12 months.  We now expect active stock-picking investment strategies coming to the fore with valuation discrepancies between and within different areas of global equity markets creating opportunities. Due to the continued uncertain outlook for the global economy, we believe that it is prudent to select a portfolio of defensive, global stocks; in particular, companies with high cash flows, which are offering enticing yields that display the potential for dividend growth to combat inflationary pressures further down the line.

UK

The upcoming General Election is providing increased uncertainty for the UK economy, with the prospect of a hung Parliament being a serious possibility (odds of 13/8 with some bookmakers). Irrespective of which party is elected, it appears inevitable that fiscal policy will be tightened sooner rather than later. Furthermore, the artificial stimulation from the quantitative easing programme has been put on hold for the foreseeable future and the economic growth prospects for the UK remain muted as domestic consumption remains subdued.

This year the UK stockmarket has shaken off a lot of concerns both home and abroad and valuations in the UK are no longer cheap in many areas of the market. Cyclical areas in particular will need the strong recovery to continue to justify valuation ratings at present. As such, we now believe that the UK equity markets as a whole offer more downside risk than upside potential.

However, there are still areas of opportunity. Following significant relative under performance in 2009, we believe that defensive growth areas of the market that offer attractive yields are good value. These tend to be larger blue-chip companies, and it is these companies that typically make up the bulk of equity income funds. These funds historically outperform the broader equity markets during periods of market uncertainty.

2009 was all about the recovery in the broader market. Now we believe the environment in 2010 is going to be about the skills of the stock-picker. Therefore, in the current environment, we also favour funds with an absolute return remit run by management teams with proven track records of making gains in challenging environments.

US

The US seems to have taken more of the pain within its economy and financial markets earlier than much of the rest of the developed world, which has put it slightly ahead on the road to recovery. However, the stimulus bail-out packages still need to be paid for and it is difficult to see where broad domestic economic growth will come from.

Despite this we are becoming more positive on the US stockmarket as it is home to a number of high quality, world-leading companies. In the 1960s and the 1970s, the top 50 most popular large cap US stocks led the market and rewarded investors who adopted a ‘buy and hold’ strategy. This is a strategy that we currently favour - investing in companies that can deliver superior growth because of their high geographic exposure to faster growing areas of the world; the industries they operate in, or because of their superior technology.

We also remain positive on the US dollar as problems in the Euro have reinforced its position as the global reserve currency. Even though we do not profess to be currency experts, we do monitor currency situations and if the US Dollar moves to $1.40 versus Sterling then we would look to hedge out currency risk.

Europe

Europe surprised many observers by beating both the US and the UK out of technical recession, but has struggled over the past couple of months and, with the exception of France, many economies are expected to re-enter recession in 2010.

Despite a sluggish economic environment on the Continent, specifically in countries such as Greece, Portugal and Spain, there are attractive opportunities to be had in Europe to take advantage of a continued global economic recovery.

The patchwork nature of the Eurozone means selective investment is crucial. Concerns over potential default risk from a number of EU members have weakened the Euro, and this could continue. This would hit Sterling investors in the short-term although a weakened Euro may ultimately be positive for the region as it boosts exporters. The historical strength of Euro against Sterling means investors should actively consider currency risk when investing in Europe.

From an investment perspective, yield is attractive in many areas of European equities and we believe that there is a place in equity income portfolios for selective exposure to Europe.

Japan

Many investors see Japan as an enigma and it is one of the most underweighted markets in most portfolios. However, when investing in Japan it is important to focus on the companies and not the economy. Many companies still have global domination in their particular area and many remain at the cutting edge of technology. Japanese firms have strong trade links with China and the rest of Asia, and their exporters typically have twice as much exposure to Emerging Markets than the Western economies.

Export sectors are likely to be the best area to focus on as we begin to see a recovery in global growth as well as further restructuring and the potential for weakening of the Yen. However, it is difficult to get excited about the potential for domestic areas of the market which is under pressure due to a number of negative demographic pressures.

The currency has strengthened considerably over the past year which has hurt the competitiveness of exporters. Many are predicting a weakening Yen in 2010 which would boost Japanese companies operating overseas. We therefore favour investing in a fund with currency hedging in place. In relative terms, Japan is now one of the cheapest markets in the world. If we do start to see positive news-flow emerging there is a lot of scope for a shift to this market leading to a strong rally.

Far East / Emerging Markets

China is still a key focus for investors and there is no doubt that it has weathered the economic storm remarkably, recovering rapidly from its deepest slump in almost a decade, and is already back on track for economic growth of 8% in 2010. This highlights that China has become a powerful economy in its own right, though much of its recovery has been driven by capital spending within a huge stimulus programme and focus now needs to be turned to domestic consumption growth.

India has also fared well and the political reforms have led to a big focus on infrastructure spending, whilst foreign direct investment is increasing. However, again it is the domestic population that remains the key focus. Household savings rates remain high (average household has 10% debt compared to 90% in the US) and stimulating stock ownership through privatization programmes will be the next big development from the authorities. 

Russia has been one of the strongest performing markets over the last year. However, the region still looks cheap on a relative basis and stock opportunities within the region are generally cheaper than in other Emerging Market countries. Economic ties between Russia and China will prove a positive factor for Russia as Chinese links will provide cheap financing for the development of Russian Infrastructure.

Latin America, led by Brazil, continues to be buoyed by strong commodity demand worldwide (particularly from China) and a burgeoning domestic consumer base that is often underestimated by analysts and commentators. The region is likely to continue to benefit from these two influences, though there is the risk of the region becoming a victim of its own success as appreciating currencies act as a brake to further growth.

The current consensus optimism about Asian Pacific and Emerging Markets does cause us some concern, with more and more industry observers voicing apprehension. Although valuations are not cheap, we still believe that there is growth potential in many areas. As such, we remain positive over the long-term but we are keeping a close eye on valuations. We are aware that the further investor exuberance could lead to valuations becoming inflated giving rise to a correction at some point in 2010.

Non-Equities

Cash

Cash returns have been paltry since base rates were slashed and we expect interest rates to remain low throughout 2010 and possibly even beyond for short-term deposits. However, interest rate rises are anticipated at some point and so long-term savers are being rewarded to tie up cash for 5 years with rates up to 5%. With the prospect of short-term low interest rates providing little return and longer term inflationary pressures meaning cash holdings are at risk of depreciating in real terms, from a risk / reward point of view the asset class remains unappealing. However, liquidity and security means cash will always have a place in the majority of investment portfolios.

Fixed Interest

Irrespective of which party is in power after the upcoming UK election, curbing fiscal spending and raising taxes are most definitely on the agenda.  In this environment, raising interest rates is something the economy is unlikely to bear and would inevitably lead us back into recession. Therefore we are in the “lower for longer” camp in terms of UK interest rates and this will support fixed interest markets for the meantime.

We are not as negative on UK government gilts as we have previously been. Support from overseas buyers taking advantage of a weak currency and banks being forced by the Financial Services Authority to buy gilts to shore up balance sheets should help soak up the large supply needed to finance UK government debt. However, we still continue to favour corporate bonds, particularly higher yielding areas of the market, which are offering attractive rewards for investors willing to take on the default risk.

Over the longer-term the biggest threat facing bonds is inflation. Whilst we cannot see domestic inflationary pressures in the near-term we are conscious of the risk further down the line and are looking at long-term inflationary hedges in bond portfolios. At present there is the option to hold index-linked gilts and bonds, but these are looking very expensive right now.

One area of interest is Emerging Market Debt. This is increasingly gaining traction as a significant asset class, and is an area that has tended to be overlooked. Within this area, it is important to focus on emerging economies where issuing governments are becoming more fiscally responsible, have stronger finances, rising currencies and offer attractive yield premiums.

Property

The steep falls in commercial property capital values have given rise to yield increases and the market has been in recovery mode. However, the tough economic climate means the backdrop for commercial property investment will remain challenging, with weak tenant demand causing falling rents. 

Despite this we believe UK commercial property offers some interesting opportunities and the IPD benchmark currently yields around 7% - very attractive versus other asset classes. In the current low interest rate environment, security of income remains a key focal point for investors and it is worth remembering that over the long term, 70% of the total return from commercial property investing comes from income.

Large, short-term flows of money into property funds have driven a level of demand that has not been matched by the supply of quality prime properties, so prices could get ahead of themselves and lead to a correction. This has happened before and investors need to be wary. However, we remain focused on the long term-view, investing in prime property funds with good liquidity. We are happy to take an attractive yield and take advantage of diversification benefits and the fact that the asset class is traditionally a reasonable hedge in times of inflation.

We have cautiously started to add a small exposure in property funds into our portfolios. We are certainly not alone on our change in stance on the asset class and we are witnessing a marked improvement in investor sentiment. In fact one hurdle for property managers could be buying good quality for their portfolios with an increasing flow of money seeking quality properties in a market that currently has few sellers. Of course the falls in value over the last three years have highlighted the risks of holding property funds - particularly liquidity risk and we will maintain an approach that will not see more than 15% invested in the asset class.

The Whitechurch Investment Team, March 2010

This article is intended to provide information of a general nature and does not represent a personal recommendation to invest or to disinvest. If you are unsure, seek professional advice before making an investment or a decision to sell your investments. Whilst we have made great efforts to ensure complete accuracy we cannot accept responsibility for inaccuracies. The past is not necessarily a guide to future performance. The value of investments and any income produced can go down as well as up and you may not get back the full amount invested. Levels and bases of, and reliefs from, taxation are subject to change.