Week in View

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.