Market Summary Q2 2010
The world economic recovery that began in the middle of last year has gathered strength through the first quarter of 2010. While the actual pace of global growth in Q1 may slightly lag that of the previous quarter, much of this is due to the impact of the severe winter weather experienced in the US and Europe.
Cyclical recovery in the emerging world has been a reality for some time but in the advanced countries GDP growth is recovering at varying speeds. Even so, the quality of growth is improving i.e. private domestic demand is contributing more to growth while unemployment appears to have peaked and income gains are improving. These are trends that need to be consolidated if the recovery is to transition into a self-sustaining expansion.
The really good news for the global economy is that while the pace of recovery is still very pedestrian throughout much of Europe, developments in the US economy appear to be progressing sufficiently well for some commentators to now believe that a durable global economic expansion may be underway. What began as a manufacturing-led rebound in the US is now morphing into something more concrete and sustainable.
Naturally, there is still some debate about the ability of the US business cycle to be sustained once policy support wanes. Recent data is pointing to the business cycle developing in a fairly typical way, however, with improving financial market / financial conditions, growing confidence and income gains. Corporates have joined consumers in spending at a faster pace than many of the economic bears believed likely and, while it is still early days, both the March ISM survey (suggesting production growth should stay strong incoming months) and non-farm payrolls report (employment now increasing) indicate the rising probability of a sustainable business cycle.
While neither the UK nor the eurozone are expected to match the pace of expansion in the US, more recent leading economic indicators suggest growth is accelerating and by enough to imply positive trends in employment. The Japanese economy has performed far better than many expected and forecasts for the year continue to rise.
The Chinese economy continues to defy the large contingent of negative pundits with GDP growth by nearly 12% in Q1. The authorities are now actively trying to rein in activity but Chinese demand remains a major support for the strong growth reported in much of the rest of Asia.
Overall, the recovery has been stronger than generally expected so far with confidence growing among consumers and businesses as well as in financial markets. The key factor generating this global turnaround is the unprecedented scale of policy intervention that has greatly improved financial conditions and real activity. The “cost”, however, is that central banks’ balance sheets have ballooned, governments have accumulated massive fiscal deficits, while short-term interest rates remain near zero. These issues, which present considerable risks are now demanding greater attention and their resolution will be a key focus for financial markets over the next few years.
Bond markets have already registered their concern in those countries with inadequate responses or insoluble problems, such as Greece which is now in need of an EU/IMF rescue programme. Bond yields have risen in a number of other European countries with severe fiscal problems but, in general, yields in the main government markets, while fluctuating have remained within the broad bands of the past twelve months. A huge increase in bond issuance has yet to offset low and generally falling core inflation, still weak domestic credit demand and near-zero policy rates. Returns from higher risk bond markets, such as corporates and emerging markets, performed far better being driven by the improved financial and economic conditions allowing spreads to continue to narrow.
This economic and interest rate/bond background has provided a further boost to risk assets with the most volatile, commodities, producing strong returns over the quarter. Industrial metals surged anew with the sector recording gains of nearly 10%. Chinese and, hoped for, OECD demand together with strong investor interest was sufficient to offset concerns of short term builds in inventories.
Equity returns were more mixed with the MSCI World equity index eventually ahead by nearly 4% over the quarter. This disguises quite a volatile period as, in January stockmarkets reacted negatively to monetary tightening in China and growing fears of bond default in Greece. Neither was sufficiently damaging, however, to hold equities down for long and the cyclical bull market reasserted itself in February.
UK-based investors received the added bonus of substantial gains in overseas holdings with the world index up 9% in sterling terms as the currency fell sharply on fiscal and election concerns.
Of the main geographic areas, Europe suffered more than most from the growing awareness of the fiscal plight of a number of eurozone countries, which also resulted in euro weakness. In local currency terms, the emerging markets performed relatively poorly
as a group, principally as a result of the poor showing by Chinese stocks, some 18% of the Emerging Market index. Once adjusted for currency out performance versus sterling, however, Emerging Market local currency gains of 1% were elevated to 8.5%.
The underlying economic improvement encouraged investors to return to riskier stocks with cyclical sectors (basic materials, industrials, etc.) far outperforming the defensives (healthcare, telecom, utilities). This also led to resurgence in the performance of mid and smaller capitalisation stocks which, in general, outperformed large caps by a significant margin.
The stunning 10% gain recorded in Q4 by UK commercial property, as measured by the IPD index, was highly unlikely to be repeated and, indeed it was not, but the near 6% outturn was still a very strong result. Investors continued to focus on Central London offices, retail warehouses and large shopping centres and, in some instances, prime yields have moved back to levels that now appear to offer only limited upside. Once again, too much money was chasing too few prime investment opportunities.
All the major economies have exited recession and nearly all commentators expect a sustained global expansion through 2011. While there were some signs of weaker data in the early part of the year this was probably weather-related and more recent economic figures have confirmed that the pace of recovery may be accelerating in the US and Japan. Q2 will be a key test of this belief but certainly more robust data should emerge from the laggards the UK and the eurozone. As for the developing world, the expansion is so well advanced that a number of countries are beginning to gradually tighten monetary policy.
There are still 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 is a key goal for the authorities but one that will eventually provide a more testing time for financial markets used to an unlimited supply of virtually no cost money.
Alongside the general belief in a sustainable global recovery (albeit sub-par in much of the developed world) and stable inflation is the expectation that short term interest rates in the developed economies will stay at very low levels for some time to come. Some small upward moves may well prove necessary during the latter part of 2010, should GDP growth meet or exceed expectations, but it is perhaps the longer end of the government curve that may present greater problems for equity markets should yields back up significantly. As noted, however, yields are forecast to rise but probably not too deleteriously for equity markets, we are a very long way from an inverted yield curve unless the recovery in the US proves far stronger than forecast. The interest rate/bond background will become less supportive, therefore, but this is a normal condition as a cyclical recovery transitions to a sustainable expansion.
After such strong returns last year, 2010 was always likely to be a more difficult year with the likelihood of more unsettled stockmarkets, although positive returns were and still are expected. As noted, some of the major issues centre on government and central bank exit strategies both of which have the potential to cause substantial volatility. Early evidence of this occurred with Chinese monetary policy tightening, the inability of Greece to convince investors to buy its debt and growing concerns about global fiscal debt sustainability.
Given these risks, equities need to be attractive to investors and as long as economic and profits expectations are met, then valuations remain very reasonable, especially relative to cash and bonds. Near term there is little to choose between the main geographic areas although currencies could continue to 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 industrials all with exposure to growth markets. From today’s levels, gains this year should still outpace those for most other asset classes.
Government bond markets, particularly in the US and UK, have been massively supported by central bank bond purchases but, with heavy issuance for the foreseeable future, longer run upward pressure on yields is virtually guaranteed. 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 palpable rise in yields is expected late this year and next. Relatively, corporate bonds are better value and should continue to outperform governments but should be considered a source of higher income rather than capital gain. Investment grade bonds offer the potential for easonable returns going forward with a further narrowing in spreads. A medium term overweight in high yield also continues to be recommended.
News flow 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 3.0% 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 in excess of double-digit total returns forecast for 2010, property should comfortably outperform cash and government bonds.