OSBR -Global Investment Strategy and Investment Allocation

OSBR -Global Investment Strategy and Investment Allocation

February 25th, 2010

The quarterly reporting season for the world’s economies is underway and those countries that have released fourth-quarter GDP figures so far have conformed to the Emerging Asia/US strong growth and Europe/UK/Japan more sluggish recovery profiles. As ever, the first to report was China, with the economy recording a better than expected 11.0% seasonally adjusted annualised growth rate. In stark contrast, the UK eked out an extremely modest and disappointing 0.4% rate. It is somewhat ironic to note that economists tend to accept the Chinese numbers yet have very little faith in the UK statistics. This is principally because UK GDP figures have been prone to sizeable revisions, especially around economic turning points and, while the official data showed the economy in recession in the second half of last year, many economists expect history will eventually show a recovery was already underway. The most eagerly awaited report in the financial markets is that from the US and fourth-quarter GDP data didn’t disappoint with the Advance Estimate, as it is known (also subject to significant revisions), showing an encouraging 5.7% growth rate – well above expectations. While much of this is attributable to a considerably slower pace of inventory liquidation, there are indications that both consumption and capital spending have been firmer than in the last two cycles. Obviously, this is partly due to fiscal policy support but also to an easing in financial conditions and, overall, the figures suggest that underlying demand continues to improve gradually. For 2009 as a whole, the US economy contracted by 2.4% (compared to the UK’s near 5.0% decline) but for the current year commentators remain significantly more optimistic with GDP growth forecasts generally within a 2.5% to 3.5% % range (compared to 1% to 2% for the UK). This optimism extends to the overall world economic outlook as all the major economies have exited recession and a sustained expansion is forecast by most commentators. The International Monetary Fund, for example, recently released its latest World Economic Outlook, revising its projections substantially higher, and estimates world output will grow by 3.9% in 2010 and by 4.3% in 2011 (after -0.8% in 2009 and 3% in 2008). A continuation of the developed economy (sluggish growth by historic standards) and emerging economy (strong growth) divide is still expected to be a key theme going forward. There are, of course, numerous risks around all growth forecasts and perhaps the main economic issue for the next year or so is balancing the necessity not to undermine recovery and ensure the transition to economic expansion against the need to begin the withdrawal of the massive monetary and fiscal stimulus. Managing these exit strategies effectively will be the key goal for the authorities but one that will also provide a more testing time for turbo-charged financial markets now used to an unlimited supply of virtually no-cost money. Indeed, the opening months of the year served notice to this effect with financial markets destabilised by exactly these issues. Any complacency following the dramatic gains by riskier assets over the prior 10 months was rudely disturbed as financial markets began to face up to the realities of exit strategies in motion. Following stronger than predicted economic and lending growth, the Chinese central bank began tightening monetary policy earlier than expected, which coincided with investors baulking at holding Greek debt, as concerns grew over not just liquidity but the sustainability of debt levels. Together with President Obama’s somewhat populist proposals to restrict banking activities, this led to a sizeable pull back in equities and commodities and a return to “safe haven” buying. In the near term, further instability is probable but there is as yet no suggestion the cyclical bull market will be completely derailed. Certainly, some rotation away from riskier assets seems advisable but the balance of risks, rather than perhaps the recognition of risk, has not changed overly. Taking all this into consideration, Old Broad Street Research (OSBR) asset allocation views are: * Equities: After such strong recent gains, global equity markets were vulnerable to the correction that has duly arrived. It has been consistently noted 2010 would be a difficult year with the likelihood of much more unsettled markets, although positive returns were – and still are – expected. The major issues centred on government and central bank exit strategies, both of which have the potential to cause substantial volatility. Early evidence of this has occurred with Chinese monetary policy tightening and the inability of Greece to effect a credible debt reduction programme. Bank regulation was another potential negative issue that has also come to the fore in the US. Given these risks, equities need to be attractive to investors and as long as economies and profit expectations are met, then valuations are very reasonable – especially relative to cash and bonds. Interest rates are set to stay low for some time to come and economic news could still surprise on the upside. In the near term, there is little to choose between the main geographic areas although currencies may play a larger role in returns. Investors will need to be opportunistic, however, and should favour a barbell of good value, defensive growth stocks, high-yielders and some industrials with exposure to growth markets. It should be a better environment for good stockpickers following the “recovery” rally for most of 2009. From today’s levels, long-term gains this year should still outpace those for most other asset classes. Bonds: Government bond markets, particularly in the US and the UK, are being massively supported by central bank bond purchases but, with heavy issuance for the foreseeable future, longer-run upward pressure on yields remains. In the near term, however, overseas central banks remain buyers as well as banks playing the steep yield curve while core inflation is low and falling in most countries. A more notable rise in yields is expected later in the year. Given the UK’s longer-term economic problems, the gilt spread relative to Treasuries – and particularly bunds – appears unrealistically tight and could widen further. Relatively, corporate bonds are better value and should continue to outperform governments but should now be considered a source of higher income rather than capital gain. Investment grade bonds offer the potential for reasonable returns going forward with a further narrowing in spreads. A medium-term overweight in higher-quality high yield also continues to be recommended but there are near-term risks of a widening in spreads. Property: Newsflow in UK commercial property continues to improve. Industry specialists have been joined by investors reinvesting in a sector where the yield pick up is still 3.5% above 10-year gilts. A shortage of prime property is squeezing prices sharply higher at the moment but as 2010 progresses higher capital values should encourage involuntary holders, such as banks, to boost supply. Even so, with forecasts of double-digit total returns next year, property should comfortably outperform cash and government bonds. Property shares have rallied strongly and valuations now appear well up with events, although there could be some further relative upside on a longer-term perspective.  Commodities: Predicting commodity returns is always a difficult call given the very broad spread, high volatility and problems associated with rolling over future contracts on returns. As long as the economic background develops as we anticipate, however, the favoured commodities – such as oil and copper, where there are clear long-term demand and supply imbalances – should perform well. Near term, however, the sector is under pressure, principally reflecting Chinese growth fears as the central bank tightens monetary policy. A substantial build-up in inventories, especially copper, is also a concern that could lead to a further near-term fall in prices. This background is hardly supportive for mining stocks and cheaper valuations may be needed to reverse current sentiment. Currencies: A counter-trend dollar rally had been anticipated through the early part of 2010 but it has been augmented by recent move towards safe-haven assets and the unwinding of the dollar carry trade. With the eurozone and Japanese economies recovering only modestly, both would appreciate a cheaper currency. The former is suffering currently from “euro” concerns driven by the peripheral counties – although Spain is now increasingly lumped in – while, for the latter, a move to safe haven currencies tends to result in yen strength. This is a trend that is anathema to the current thinking of the Japanese authorities and further quantitative easing may be initiated to alleviate it. On a long term view, the commodity and selected emerging market currencies continue to be favoured although further near-term weakness is probable. Old Broad Street Research works for many of the best-known firms in the financial services industry, offering products and services to fund managers, product providers, wraps and platforms and large distribution firms as well as to individual advisers. The firm’s research is highly regarded by fund managers, product providers and professional intermediaries alike, with OBSR Fund Ratings widely acknowledged as an independent mark of quality. For investment advice please contact Mark or Clare at GMP Independent Financial Advisers LLP 

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