Since my last review in December 2009, markets have been volatile and the FTSE100, for example, has increased from about 5200 to 5800 in April 2010 and today (14 June 2010) stands at 5192 (Source BBC Business 14 June 2010). As I have commented on many previous occasions, markets hate uncertainty and this currently abounds in Greece (sovereign debt problems), Spain (banking problems), Portugal and Ireland (spiralling deficits and uncompetitive wages), North & South Korea (potential warfare), China (inflation), Australia (super-tax on resource companies) and, until very recently, the US (banking reform) and the UK (budget deficits). That’s a very long list and it’s no surprise that markets have fallen about 10% from their recent peaks.
There is also little doubt that the recent recession was different from others which went before. In the US, for example, Schroder’s chief economist, Joshua Shapiro stated last week that, in his opinion, there will be a cyclical upswing fuelled by expansive fiscal and monetary policy. However, he also stated that this upswing is likely to be dampened by ongoing deleveraging and correcting past excesses. Translating this to the UK, it is difficult to see any cyclical upswing from cutting £6.2 billion in public sector spending (announced by George Osborne on 24 May 2010) and the decrease in public sector employment which will inevitably follow. The UK’s Coalition Agreement has also indicated that tax rises in the 22nd June 2010 Emergency Budget are inevitable. Policymakers need to be careful to avoid a second recession created by cutting spending and increasing taxes too quickly and by extremes. In the UK, deleveraging and the ongoing correction of past excesses are likely to drag our economy for some years to come.
The message so far is that economies are suffering and could continue to do so. Why should investors commit or retain money in investments in these conditions?
It is important to understand the link (or, to be more accurate, the lack of a link) between economic conditions and stock-market returns. The lack of correlation between these two was most recently in evidence when the FTSE100 rose from about 3500 in March 2009 to about 5500 in March 2010. This was not a result of a fundamentally better economic situation; it was a result of improved sentiment, investor desire to take more risk, low interest rates and a realisation that the end of the world was not nigh!
UK investors have seen virtually no return in stock markets over the last 10 years. Data from Barclays Capital shows that UK stock market returns over the last 10 years have only been 1.6% per annum but if you increase the timeline to the last 25 years, this figure increases dramatically to 10.4% per annum; 110 years data shows an average of 9.3% per annum [Source: Sarasin and Partners Investment Compendium January 2010]. These markets are unlikely to revert to these performances instantly but, on a historic basis, equities are well overdue for more positive returns.
The Equity Risk Premium (a widely held method of establishing the cheapness of stock markets against bonds) is currently higher in the US than at any time between 1982 and 2008 (Source JP Morgan May 2008). This suggests that equities are still cheap despite the increases in markets indicated earlier in this note.
Companies worldwide are reporting increased earnings. In the US, corporate profit share as a percentage of Gross Domestic Product fell from a peak of about 14% in 2006 to a trough of about 9% in 2009 [Source Schroders Q4 2009]. This has now risen to about 12% and Schroders are predicting further modest rises in 2010/11. Standard Life Investments expect the combination of cost cutting of UK companies in the recession and increased earnings as the cycle improves to have an unexpectedly sharp effect on increasing profitability.
So, my quick trip round asset classes follows:
Cash. There is considerable disagreement about when interest rates will rise and by how much. In these circumstances, it is probably sensible to avoid locking into long fixed term rates even at what might appear to be attractive rates in today’s low rate environment. Nevertheless, it is important to ensure that all assets (including cash) are delivering the very best returns so active cash management is vital across portfolios. With base rate at 0.5%, it still seems sensible to buy into 1 or 2-year fixed rates at 3% (where available). If interest rates rise in this period, it seems unlikely that banks will pay even higher rates of interest as current margins are clearly very tight.
Fixed Interest. Investment Grade Corporate Bonds have been a one-way bet for some time. Returns have been excellent in capital growth and income terms (from a very low base point). Our view is that the risk in remaining in fixed interest funds is acceptable (as the likelihood of high inflation or high interest rates is modest) but it is time to diversify your exposure using strategic funds (where the manager decides the balance between investment grade and high yield), overseas bond funds (to diversify sovereign risk) and even selected emerging market debt funds.
UK Equities. These look good value for the longer term at today’s prices. 70% of earnings of UK companies arises from overseas trade [Source M&G March 2010] so there is a dislocation between the profitability of UK companies and the performance of the UK economy. The economy is likely to continue to suffer but that should not prevent UK companies from performing well in the medium to long term.
Overseas Equities. Whilst Europe appears to have its own problems, the US looks to be coming out of the recession strongly. Emerging Markets still appear to offer real growth opportunities with the Asia Development Bank predicting growth rates of 7.5% in 2010 and 7.3% in 2011. (In comparison, the IMF is predicting 3.1% and 2.6% respectively in the US and 1% and 1.5% in the Eurozone). [Source Fund Strategy Magazine 24 May 2010]. Whilst stating earlier that there is little correlation in the UK between the economy and stockmarkets (due to the positive impact of overseas earnings), globally, this is not the case and a strong economy will have positive momentum on markets.
Property. Investor sentiment globally remains negative. Jim Rehlaender (one of the best known property fund managers of European Investors Inc) said in May 2010 that the economic fundamentals are increasing rapidly and are now the best he has seen for 10 years (especially in Asia). He also stated that a lack of current commercial development would lead to supply shortages within 2 years. He expects the US to bulldoze up to 2 million houses which were built on completely undesirable sites; some replacement in good locations will be required. He is also positive about Europe which also shows some really strong fundamentals which are currently hidden by the macro problems highlighted earlier in this Commentary.
Commodities. It seems obvious that increasing global demand will support commodity prices generally. Which specific commodities win or lose is not a call we would make and we would recommend exposure to this asset class though a basket of different commodities available in funds.
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.
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Historic Long Term Average (Source: Sarasin January 2008) since 1900
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Pearson Jones “House View” over short-medium term (short-term = 1-2 years; medium-term = 3-5 years)
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Inflation
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3.9% p.a.
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Average short and medium-term Remains a threat of higher figures at any time due to policy error.
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Equity Returns
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9.5% p.a.
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Unpredictable short term reverting to average in the medium term.
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Gilt Returns
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5.2% p.a.
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Below average short term remaining so for the medium term
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Cash Interest Rates
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5.0% p.a.
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Well below average short to medium term
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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
peter.heckingbottom@pearson-jones.co.uk