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Despite some uncertainty over the recent optimism surrounding the outlook for the global economy, equity market performance reasserted itself on further signs of stabilisation in the banking sector, as Wells Fargo announced expectations of better-than-forecast Q1 results. The week to 13 April saw most developed stockmarkets up between 1% and 2%, with commodities following suit (as measured by the CRB index).

 Market Movements

Key themes for the second quarter

Notwithstanding the mood change, there clearly remain some tailwinds for financial assets. Arguably, equities and corporate credit are both cheap. Global dividend yields are at their highest level for almost 30 years, while corporate credit spreads remain exceptionally wide, thus exaggerating the default rate that we are likely to see.

The global recession is not over but, arguably, the most intense phase is. Equity markets tend to recover maybe six to 12 months before there is strong evidence of economies turning and, given that we expect such an environment moving into 2010, it would not be an unlikely development for equity markets to continue to try to ‘sniff out’ a possible recovery in the coming months. Nevertheless, markets still face a number of strong headwinds.

The banking crisis is not over and is going to drag on into 2010. In the interim, it is quite likely that we will see further episodes of heightened volatility, maybe significant ones, over the next few months. Outside of the banking system, expect to see significant weakness in corporate earnings also. And, in thinking that we can return to the world of positive, rather than collapsing, economic growth, the speed of recovery is going to be slow, leaving us in a growth-challenged world not only this year, but also in 2010.

For all the concerns about inflation, because of what central banks and governments are doing, it is possible that the threat of deflation is likely to loom larger than the threat of inflation.

The implications for different asset classes

An important starting point in terms of investment policy is that cash rates are now effectively zero. This is a significant difference from where we were only 12 months ago.

Although government bonds offer poor value from a long-term perspective, with central banks being big buyers in the market, I think it is too early for material breakouts on the upside in terms of yields. Consequently, I think government yields will remain around their current level until we enter a more normal economic environment, which could take several quarters.

As mentioned above, there remains genuine value in corporate credit. While we see value across all corporate credit products, the returns in investment-grade credit are potentially such that there is no need to go too far down the risk spectrum at the moment.  We have been recommending this area for the past 6 months and it is still not too late to get involved.

In terms of equities, the bottoming-out process is continuing, but we do not expect markets to break the lows that they have been testing over the past six months. We believe there is some upside potential if the improvement in economic conditions is stronger than anticipated. Conversely, equities could be undermined by the feeble nature of any recovery, particularly following the recent price rally, and additional shocks in the financial sector.

Peter Waller - Investment Director

Equity, currency and bond markets measured from previous Friday’s close to Friday’s close. All index returns in local currency terms. All equity index returns are price only. *Bonds: 10-year yield.

The Bank of England’s Monetary Policy Committee today voted to reduce the official Bank Rate paid on commercial bank reserves by 0.5 percentage points to 0.5%, and to undertake a programme of asset purchases of £75 billion financed by the issuance of central bank reserves

World activity continued to weaken, reflecting both depressed confidence and the persistent problems in international credit markets. In the United Kingdom, output dropped sharply in the fourth quarter of 2008. That reflected lower consumer spending, a further fall in business investment and a rapid run-down in stocks, in part offset by stronger net exports as the past depreciation of sterling began to take effect. Business surveys continue to point to a similar rate of contraction in the early part of this year. Unemployment has risen markedly. Credit conditions faced by companies and households remain tight.

CPI inflation declined to 3.0% in January. The depreciation of sterling is adding to imported cost pressures, but pay pressures continue to wane. Inflation is likely to fall below the 2% target by the second half of the year, reflecting diminishing contributions from retail energy and food prices and the impact of the temporary reduction in Value Added Tax.

At its March meeting, the Committee noted that the February Inflation Report had implied a substantial risk of undershooting the 2% CPI inflation target in the medium term and that a further easing in monetary policy was likely to be needed. Data released since the finalisation of the Report had not materially altered that prospect. Accordingly, the Committee concluded that a further easing in the stance of monetary policy was warranted. But the Committee also noted that a very low level of Bank Rate could have counter-productive effects on the operation of some financial markets and on the lending capacity of the banking system. On balance, the Committee decided to reduce Bank Rate by 0.5 percentage points, to 0.5%.

The Committee judged that this reduction in Bank Rate would by itself still leave a substantial risk of undershooting the 2% CPI inflation target in the medium term. Accordingly, the Committee also resolved to undertake further monetary actions, with the aim of boosting the supply of money and credit and thus raising the rate of growth of nominal spending to a level consistent with meeting the inflation target in the medium term.

To that end, and noting the recent exchange of letters between the Governor and the Chancellor of the Exchequer concerning the use of the Asset Purchase Facility (Click here to read Chancellor Darling’s letter to Mervyn King at the Bank of England) (read Mervyn King’s response, please click here)for monetary policy purposes, the Committee agreed that the Bank should, in the first instance, finance £75 billion of asset purchases by the issuance of central bank reserves. The Committee recognised that it might take up to three months to carry out this programme of purchases. Part of that sum would finance the Bank of England’s programme of private sector asset purchases through the Asset Purchase Facility, intended to improve the functioning of corporate credit markets. But in order to meet the Committee’s objective of total purchases of £75 billion, the Bank would also buy medium- and long-maturity conventional gilts in the secondary market. It is likely that the majority of the overall purchases by value over the next three months will be of gilts.

At its future meetings, the Committee will monitor the effectiveness of this purchase programme in boosting the supply of money and credit and in due course raising the rate of growth of nominal spending, adjusting the speed and scale of purchases as appropriate.

The minutes of the meeting will be published at 9.30am on Wednesday 18 March.

Please click HERE to read the News Release

The market’s dividend yield approaches 5% and shares look very cheap.

Amid all the bail-outs, bankruptcies, meltdowns and mayhem, there’s one market signal that keeps flashing ‘buy’.

During the last few months, the dividend yield on the FTSE 100 and All Share indices have reached almost 5%. That’s the highest income since the early Nineties and it now exceeds the yield on offer from 10-year gilts (government bonds).

(Source: Daily Telegraph 4^th February 2009)

The last time shares in general yielded more than gilts occurred right at the bottom of the 2000-03 dotcom crash.

Had you bought the All-Share back then, you’d have more than doubled your money four years later. Beyond that single day during March 2003, I think you have to go back at least forty years to find the last time the market’s dividend yield topped the income from gilts.

So why does this so-called ‘reverse yield gap’ signal a market ‘buy’. It effectively means investors have become so depressed with their shares that they think aggregate company payouts will shrink over the long run. That belief, however, defies decades of market history. During the last fifty years for example, dividend payments from London shares have grown a collective 30 times according to the Barclays Equity-Gilt study.

Certainly there is going to be some short-term dividend pain. Banks for instance have very uncertain payouts at present. The sector represents 15% of the All-Share index and yields 8%. If aggregate bank payouts halve in value, the market’s yield could fall to 4.3%. If bank dividends disappear completely, the market’s yield could fall to 3.7%.

The other worry is that gilts could be the wrong ’safe haven’ comparison.

So what now? The headlines are grim, share prices keep falling and there are plenty of reasons not to buy. But that was the case during March 2003, on Black Monday in 1987 and when the Seventies bear market bottomed during early 1975. All were extremely anxious times, but all proved to be first-class buying opportunities for patient investors. For now at least, there’s a market signal that keeps flashing ‘buy’ and

I for one am still backing the index.  

Peter Waller - Investment Director

Good article in the Daily Telegraph, written by Tom Stevenson an investment commentator for Fidelity.  Short read and worth it for eveyone.  Please click here to access.

Governor of the Bank of England (BoE) Mervyn King yesterday delivered a seminal speech, detailing what has gone wrong with the global economy, stating that despite recent interest rate cuts there remains a risk that inflation will fall below 2% (thus implying further rate cuts), and exploring both conventional and unconventional policy responses.

King explained that conventional policy responses (such as those tried in Japan) include the buying of government bonds. He explicitly stated that ‘at some point’ the BoE would consider buying corporate bonds, explaining that credit spreads are twice as high as in September, and the BoE estimates that a significant portion of this spread is an illiquidity premium. Purchasing corporate bonds would remove some of this illiquidity premium and thereby raise the value of assets that are currently under priced. The BoE’s actions would encourage companies to issue bonds, improve trading activity and reduce companies’ reliance on bank lending. Crucially, he suggested that the Monetary Policy Committee may adopt such measures as an instrument of monetary policy. More details will be announced at the end of January.

As corporate bond investors, we want to understand what assets the Bank of England will buy, and buy them first. King provided a few clues. The BoE wants to provide temporary liquidity – it does not want to artificially support markets for which there is no underlying demand. Any intervention would be directed only towards markets which normally play major roles in the functioning of the financial system. And, very importantly, the BoE will consider buying ‘only high quality assets’ – it wants to avoid taking much more credit risk onto the public sector balance sheet.

We can assume, therefore, that the BoE will only purchase investment grade corporate bonds. We would expect purchases to be made in industrial companies. It is also conceivable that purchases will be made in senior bank bonds. We can also be reasonably confident that it will not be purchasing deeply subordinated bank bonds, which carry lower credit ratings (RBS Tier 1 bank bonds were downgraded to high yield status on Monday, for example). Asset-backed and mortgage-backed securities are already being purchased under a different scheme, so it also seems unlikely that these will be included.

We believe we are very well positioned to benefit from any programme of buying corporate bonds, if indeed the BoE decides to implement this policy action.  M&G’s and Invesco Perpetual’s corporate bond funds have long had a large exposure to industrial investment grade corporate bonds, and where they have bank exposure, they hold more senior bank bonds.  Both these funds are used within our asset allocations.  If you would like to check these, please click here .

This should prove good news to those of our clients with a fixed interest element to their portfolios and confirms the thoughts in our December valuation report.  We continue to recommend corporate bonds over cash.

Please click here to read our investment report for December 2008