The period since the tragedy of 11 September has been far more buoyant than anyone witnessing the devastation could have hoped. The prompt and significant actions taken globally have boosted liquidity, lifting markets.
The first issue must be how economies and markets respond to a slowing of the liquidity injections. The consensus as expressed in earnings estimates and forecasts for economies is of a recovery – for Q3 2001 substitute Q3 2002. This recovery is built on increasing confidence that the UK economy will begin to grow. So with the predictable uncertainty that attends any forecast – what are we doing for our clients?
First, we are resisting the temptation to force our bets. Looking at the broader asset allocation of our portfolios we see low relative bets. We are underweighting the US, concerned that valuations are still too high. By contrast we are overweight the core countries in the Far East (ex-Japan). This translates into a small underweight of the predominant US market with the money raised serving to double the weighting in the Far East. We see this as a two-way bet. If the US does recover next year then the Far East should prosper. If not, the low valuation and hint of self-help from corporate restructuring should support it.
Then, with a hint of chauvinism, we favour the UK market. It is difficult to believe, but the UK appears best able to resist the global slowdown. The monetary policy committee has cut interest rates. This, combined with the boost to the economy from expansionary government spending, which pundits felt would overheat the economy when first announced, is likely to keep the economic pot bubbling. The consumer is also resilient.
The European story is less attractive. The economies are now falling into recession, the reaction of the European Central Bank is seen as tardy and the prospect of fudging the budget deficits is undermining credibility. This leads us to underweighting the region; the money used to raise the investment in the UK. Japan remains mired in a long recession with no apparent solution.
The bond markets are the inverse to the equity markets. The flight to safety and the immediate injection of liquidity was a powerful spur immediately following September. This has been given back in recent weeks, as market participants feared economic revival. This leaves the bond market in a similar quandary to the equity – but again only the inverse. To see bond yields lower requires an even gloomier outcome than currently expected. The UK market will be the exception as the force of pension legislation has precipitated indiscriminate buying of long-dated bonds to meet liabilities. The other G7 markets have long yields at roughly comparable levels.
The recent performance of equities has been poor, with two years of falling markets. We remain committed to equities as the best long-term investment for our clients. We have focused our research on the identification of companies that can prosper in an environment of low inflation, little pricing power and increasing global competition.
The first area we would consider is technology. We continue to believe in the long-term growth of the market. However, the conviction that persuaded us to buy technology in late September, having been bears for the previous period, is now lacking – we recently moved underweight. The other global sectors are finance, pharmaceuticals, energy and telecoms.
Our current position is to adopt a neutral stance in all of these sectors. We are looking for clarity on the macro picture before changing the relative weightings that we have adopted for our clients. If the accepted outlook of increasing economic activity comes about then we would see a reduction in the pharmaceuticals sector and a build up in the economy sensitive areas.
It is worth considering how the consensus could prove wrong. The bearish arguments encompass the developments in Japan and the apparent similarities with the US only lagged by around 10 years. The US has experienced a nearly a decade of growth. This has fuelled a stock market which even now sells at multiples above those prior to the 1987 crash. The consumer has sustained the economy in the face of rising unemployment and historically high personal debt levels. In addition over this period the US has moved into deficit. Japan continues to struggle to resolve its crisis and Europe has toppled into recession after a relatively mild slow down in global growth.
The bullish stance depends on the boost from low interest rates, loose fiscal policies, the fact that the markets have declined for two years and the expectation that following cost cutting earnings will expand quickly. Perhaps the prosaic reality is that we are now in an era of lower nominal returns and equities will outperform but while the real amount is reasonable the nominal return will be in single digits. So on balance we remain optimistic.
Dominic Fisher is chief investment officer of Singer & Friedlander Investment Management in London