MARKET OUTLOOK

Market Outlook

World equity markets have suffered a correction in the region of 20% since hitting cyclical highs in April. This amounts to more than $8 trillion being wiped off the value of world stocks on concerns the US would default on its debts, S&P’s decision to downgrade USA’s AAA rating, another batch of weak economic data releases, the IMF revising downwards global economic growth forecasts, markets driving bonds yields on Spanish and Italian papers above the critical 6% ceiling which would hamper their ability to repay debt and the Euro-zone debt crisis which could lead to the disintegration of the Euro.

There is also genuine concern about the sustainability of the US recovery, the ability of policymakers’ to tackle the debt and the prospect of a double deep recession. Policymakers and central banks have been criticized for being caught napping and responding too slowly to the crisis and the ECB in particular for tightening interest rates too quickly when the recovery is still fragile.

Meanwhile the global risk appetite index which is a broad measure of investor confidence hit an all time low in August which exceeded previous “deep panics” in August 1982, October 2002 (the dotcom and 9/11) as well as November 2008 (credit crisis) which implies markets are “heavily oversold.”

The sell-off is purely a reflection that the markets face stronger headwinds in the aftermath of the credit crisis than previously anticipated due to global debt levels, debt deleveraging and global economic rebalancing; which in turn has led to a dip in consumer confidence and which could potentially reduce corporate spending plans and trigger a double dip recession. In our view this is highly unlikely but of course the risk is that consumer spending which accounts for two thirds of many developed economies is adversely affected by declines in consumer confidence triggered by the market volatility. It is almost like the markets precipitating a recession or a case of “the tail wagging the dog!”

USA

US stock market turmoil can be attributed to debt default concerns which never materialized, losing its AAA rating following a credit downgrade by S&P and increased pessimism over economic growth prospects after Q2 GDP growth came in slightly below expectations at 1.3% versus 0.4% for the previous quarter. This is simply a wake-up call that the US needs to implement a credible deficit reduction plan to restore market confidence in the country’s creditworthiness. Interestingly, softer economic data releases coincides with the withdrawal of the FED’s second round of quantitative easing at the end of June. Whilst many commentators are predicting doom and gloom claiming the authorities have exhausted all the available tools to tackle the crisis the reality is somewhat different. The Federal Reserve has already come out fighting saying it now expects to keep its zero interest policy well into 2013 and a third round of quantitative easing is also on the cards. Assuming these initiatives are successful in bringing a degree of calm to the markets and restoring consumer confidence, despite our expectations for below trend growth, there is no reason why stock markets should not recover from current levels in Q4.

Europe

We expect the economic recovery in Europe to trail the developed and emerging markets due to the scale of the austerity measures which require governments, businesses and private individuals to reduce their debts to more sustainable long terms levels. The financial markets are applying pressure on debtor states, the so called PIIGS, questioning their resolve to drive austerity measures claiming low economic growth and fiscal slippage will hamper plans. We have already seen markets push bond yields on Spanish and Italian paper over the 6% threshold above which funding becomes unsustainable. The ECB had to purchase Spanish and Italian bonds to bring short term relief. Greece requires another bailout and S&P have downgraded their debt rating to CCC which places them a notch above default. Even France has come under fire with rumours they could be the next country to lose their AAA rating.  Such is the scale of the problem that the European Financial Stability Facility needs to be increased significantly in size to accommodate potential bailout requirements. Increasing the borrowing capacity of the EFSF potentially impairs the credit rating of its main backers Germany and France raising their own debt-to-GDP ratios well above 100%. The Germans are already questioning the legality of having to fund bailouts and six prominent euro-sceptics have brought this matter to Germany’s highest court for a ruling. Some have suggested greater fiscal harmonization as a way out of the crisis and have mooted the idea of creating a common Eurobond but how should such a bond be rated given the disparity between German and Greek bonds when it comes to ratings? The pain of austerity will eventually force these debtor states to break away and form their own weaker Euro and with it the possibility to restore growth through currency devaluation. We have a positive outlook on good quality blue chip euro-zone equities over the longer term.

United Kingdom

The ability to set interest rates, manage its currency and control fiscal policy allows the UK to manage their economy more efficiently than Europe. But the UK is also saddled with debt. Growth prospects remain weak with Q2 GDP coming in at +0.20% in line with official forecasts but below the 0.50% increase registered for Q1. The Bank of England have cut its growth forecasts for 2011 from 1.80% to 1.50% on concerns that rising oil prices, the tsunami in Japan and debt levels across the EU; risks which if they materialize can have a significant impact on the UK economy. In terms of stock market valuation equities are very attractively priced trading at just 9x forward price earnings whilst the dividend yield on the FTSE at 3.8% compares quite favourably with the ten year gilt which yields just 2.7%.

 Japan

Japan’s machinery orders rose for a second consecutive month in Q2 as firms increased their corporate spending to restore production disrupted by the March 11 earthquake and tsunami. Production and export data coming out of Japan suggests the private sector has recovered faster than initially expected. But increases in oil prices, a very strong Yen and debt worries coupled with Moody’s downgrade of Japan’s sovereign debt rating threaten to derail any recovery. The Yen needs to depreciate perhaps quite significantly for the economy to enjoy a sustainable recovery and for the stock market to rally. We are not convinced a recovery is around the corner and maintain our negative outlook.

 Asia and Global Emerging Markets

The Asian economic powerhouses of China and India continue to apply market-cooling measures which come mainly in the form of interest rate hikes to curb inflationary pressures from taking hold and creating an asset bubble which inevitably would end in a hard landing. Meanwhile the IMF has welcomed the appreciation of the Yuan as a tool to tame inflation and for global economic rebalancing purposes. Despite the faltering economies of the developed nations and internal measures to dampen growth the Asian and GEM’s continue to power ahead? According to a new wealth report by 2012 China and India alone will account for 40% of global growth. Given the long term growth potential of these markets we maintain a positive long term outlook.

Inflation

Over the coming months we expect inflationary pressures to ease on the back of weaker global economic activity (particularly in the emerging markets such as China and India) which should drive down food and energy prices.

Interest rates

The global economy and developed markets in particular face strong headwinds as economies recover from the credit crunch. With the recovery looking to take longer than originally anticipated and downside risks to the economic outlook likely to remain high central banks will have to loosen their monetary policy to avert a double dip recession. We expect the US to maintain its zero interest policy well into 2013, the BoE to keep interest rates at current levels and the ECB will have to reverse this year’s interest rate hikes of 50 basis points to prevent the EU from slipping back into recession whilst the SNB will keep interest rates at or near 0% due to the strong currency.

Government Bonds

The financial health of many of the so-called developed economies is such that many investors are wary of purchasing large amounts of public debt for fear of not being repaid. There is a danger that sovereign debt yields will rise on the back of default concerns. Emerging economies with large trade surpluses, low level of debt, large export sectors and high domestic savings rates are a much safer bet on a risk/return basis. We maintain our negative outlook on the sovereign bonds of developed nations but on a case by case basis would consider purchasing emerging market debt.

Corporate Bonds

Corporate bonds remain attractive preferring paper with maturities up to five years to protect against capital losses although little risk for rate hikes exist in the current environment. We also favour high yield bonds which offer attractive yields of around 8% but investors need to tread carefully if they choose to buy individual papers analyzing issuers to ensure they have the ability to repay. We maintain a positive outlook on corporate paper.

Currency

We expect a weaker Yen as the currently high valuation is very damaging for the export sector. The CHF continues to benefit from its safe haven status but the Swiss National Bank has already cut interest rates to zero and threatens to impose penalties on Swiss Francs deposits resulting in negative interest rates if the currency appreciation continues. The Swiss franc is massively overvalued and we expect it to depreciate in value. The Pound Sterling is undervalued against other currency blocs and should recover in tandem with the business cycle. Although the US Dollar is also undervalued high levels of indebtedness weighs heavily on the currency.

 Alternatives

There is now doubt that another financial crisis or a double dip recession would be disastrous for commodities which perform best when the outlook for the global macro-economic environment is improving. Some commentators argue that the benefit of holding commodities as a risk diversifier has been lost and that the asset class no longer has a low correlation with other asset classes. This may well be true but there is no denying the fact that rising demand from emerging markets particularly China, number one consumer of nickel, copper, aluminium etc coupled with supply constraints are a powerful argument for holding commodities. The prospects for this asset class are intrinsically linked to the long term growth story of GEM’s. Meanwhile Gold continues to benefit from its safe haven status and Central Banks keen to diversify their reserves are a powerful source of demand. Despite the uncertainty and the volatile nature of the asset class given the scale of the correction and the fact that we do not subscribe to the view that the global economy is heading towards a double dip recession we remain cautious but keep a positive outlook. For the more risk averse investors capital and soft protected notes are recommended.

 Conclusion

The global economy faces a period of below trend growth with strong headwinds caused by debt deleveraging, fiscal tightening and global economic rebalancing. Even though we are of the opinion that a double dip recession can be averted there is a risk that complacency, inaction and lack of coordination by the EU, G7 and G20 may lead to a crisis of confidence which, if allowed to fester, may have a damaging effect on consumer spending which accounts for two thirds of many developed economies. This coupled with falling equity prices may just push the global economy over the cliff. We are concerned that the mismanagement of the EU crisis may have a contagion effect but we do not subscribe to the view that the authorities are running out of tools to address the problem if anything they are running out of time.

Markets are driven by people and the herd mentality often takes over clouding many of the issues we face. The EU crisis has the potential to trigger a double dip recession but if properly managed equity markets should recover from here. Investors’ who are able to withstand the short-term volatility, take a long term view and who have or are thinking of re-entering the markets following the sharp fall in prices will find valuations at very attractive levels with price-earnings multiples in single figures and excellent dividend yields.

SEPTEMBER 2011

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