INVESTMENT COMMENTARY – SEPTEMBER 2010

September 15, 2010

Our Investment Director, Peter Heckingbottom, provides up-to-date comment on financial markets and investment issues/strategy.

2010 has again seen volatility in equity markets (stock markets) although the FTSE100 index closed on 31 August just 0.7% higher than on 1 January.  In this time, markets have been as low as 4805 (1 July) and as high as 5825 (15 April), a range of some 1020 points [Source Yahoo Finance September 2010].  This volatility could continue and this may result in investors’ reluctance to commit their money to markets.  This would potentially be a mistake for reasons I will cover later in this Commentary.
Central banks in the US and the UK appear keen to maintain the fiscal stimulus created by low interest rates and Quantitative Easing.  The regular minutes of the Monetary Policy Committee (MPC) Meetings at the Bank of England evidence flexibility in response with no particular leanings in the direction of strengthening or loosening policies (strengthening would be increasing interest rates, loosening would be further Quantitative Easing).  Only one member of the MPC (Andrew Sentance) is currently (18th August) voting for interest rate rises.  Capital Economics rate members of the MPC against various factors and Andrew Sentance is currently rated as the most maverick member (i.e. he deviates most from the majority view).  Controlling the fiscal stimulus would appear to be a key target if the improvements in global economies can be maintained.  Loose policy could result in high levels of inflation and tight policy could result in a double-dip recession.  Policymakers seem keener in avoiding the latter rather than concerned about the former.
The June Emergency Budget brought few real policy surprises with taxes generally increasing and Government spending reducing.  The UK and most developed market economies remain fragile and these policies are expected to remain in place for a number of years before we see real recovery.
Nevertheless, corporate profits (which are seen as key drivers to stock markets) are not slowing.  In the US, the ratio of actual earnings exceeding forecasts is the third highest on record [Source JM Morgan August 2010].  JP Morgan are beginning to see some slowing in 2011 forecasts but they still expect upgrades to exceed downgrades in 16 of the 24 markets which they track.
Equity markets still offer the potential for good long-term value to investors.  There are currently strong reasons to be positive in investing in lots of equity markets:

• The top 100 UK companies receive about 70% of their earnings from overseas trade [Source M&G Investments March 2010].  A slow UK economy should have no effect on these earnings.
• As a result, the expectation for the future profitability of UK companies remains strong.  This should be very supportive of stock markets despite a poor domestic economic outlook.
• Smaller UK companies (the FTSE250 and the FTSE Small Cap in particular) are also profitable in niche areas and are the target of Merger & Acquisitions from the UK and overseas [Source: Standard Life Investments’ Harry Nimmo Investment Adviser Magazine 13 September 2010]
• The dividend yield on the FTSE All Share is currently higher than the 10-year Gilt Yield.  This cross-over has, in recent years, proved to be a good sign to buy equity based investments [Source Invesco Perpetual, Neil Woodford, September 2010]
• In emerging markets, there is a strong impetus from:
  o    The emerging middle-classes (The World Bank predicts that this population will reach 1.5 billion by 2030, – about double the combined middle-class of the US and the Eurozone)
  o    The impact of infrastructure spending on local engineering and construction companies
  o    Export orientation of these economies with low labour costs, growing skill levels and large capital investments
  o    The impact of large quantities of Natural resources (with an estimated 80% of oil reserves and 50% of iron ore reserves in these economies)
  [Source JO Hambro Capital Management 30 August 2010]

• Warren Buffet, one of the most successful US investors, recently commented that he was a huge bull on the US market.  Although other economists/commentators hold a contrarian view, he stated there would be no double-dip and predicted the companies in which he invests would progress strongly.  Despite poor press sentiment, he expects his companies to employ more staff and produce higher profits [Source : Investment Week 14 September 2010]
  To provide some balance to this Commentary, I must highlight Capital Economics’ continuing bearish (i.e. more pessimistic) expectations.  They expect the FTSE100 index to be about 5200 at the 2010 year end with gilts yielding 2.75% [Source: Capital Economics 14 September 2010].

As regards asset classes, our key messages follow:

• Clients should be strongly underweight in sterling cash deposits.  These are currently delivering negative real returns (after tax and inflation).  Clients who are overweight cash deposits should be seeking advice about alternative investments.

• Fixed Interest investors need to take some action.  The fixed interest market is cyclical (unlike equities which tend to deliver positive trend over time).  UK Investment Grade Corporate Bonds have been a one-way bet for some time.  The jury is out as to whether the future will bring deflation or inflation.  If it’s the latter then Investment Grade bonds and Gilts could suffer capital losses.  Some protection should be provided by High Yield (because returns can be similar to equities in some market conditions).  Delegating this investment decision to a quality UK or global strategic bond manager would appear to be a sensible strategy

• UK Commercial Property is still attractive from a long-term valuation and yield perspective.  Defaults and voids remain the key risks as adverse movements in either could reduce values.  Nevertheless, we are happier recommending some allocation to this asset class (within individual asset allocation recommendations) than we were 2 years ago

• Equities in general appear to offer good value for the reasons quoted in this document.  Short-term volatility is the potential enemy to a lump-sum investor and phasing into markets reduces the risk of buying at the wrong time.  Ensuring portfolios include enough Global and (where tolerances permit) Emerging Market exposure will be likely to be the key to benefiting from long term returns.  Readers will note that this is not a “Buy Now to make a short term profit” message; rather it is an observation that long term investors should not be afraid of investing up to their maximum weight in equities in current market conditions.

To plan finances sensibly, clients and Pearson Jones’ Consultants must make educated assumptions for the future.  To provide a basis for this, the following “House View” should prove useful.

Past performance is no guide to the future and no statement in this commentary constitutes any form of individual advice or guarantee.

Information in this document represents a consensus of views from various sources including those of Pearson Jones plc.  Readers should not act on the comments made in this document without the benefit of Independent Financial Advice from a Pearson Jones Consultant.

PETER HECKINGBOTTOM FCIB APFS
Chartered Financial Planner
Deputy Managing Director & Investment Director