Global Economy Now Stabilising
- Economic stability appears to be approaching, but don’t expect a rapid rebound in growth.
- Our equity portfolios have profited from recovery - Alpha portfolio up 20% in April!
- Equity price momentum on the point of turning up - prepare for a new bull market.
- We re-establish an exposure to commodities in anticipation of a turn in the commodity cycle.
Over the past month we have seen convincing evidence
globally that the rate of decline in economic activity has
passed its low point and that the banking crisis has been
contained. The result of the US Treasury’s authoritative
stress tests was that the US banks needed to raise “just”
$75 billion to restore prudent capital ratios. This is easily
manageable and, together with improved financial results from the major banks in the first quarter of this year, has
done much to reassure markets that the banking system is
moving out of intensive care. Inter-bank lending rates of only 0.7% in the US and 1.3% in the UK reinforce the message
that normality is returning to the global banking system.
The economic news has also been reassuring. In the UK, after
a fall in gross domestic product of -1.9% in the first quarter, it
now looks as though the economy may only shrink by -0.5%
in the second quarter. Consumer confidence has risen and
retail sales grew by a healthy 0.3% in March, bolstered by
lower mortgage rates. De-stocking by companies appears
to have reached a turning point so industrial production is
stabilising, helped by a sharp recovery in exports in April as
the 25% fall in sterling made UK goods more competitive
overseas. The chart overleaf shows how expectations of
UK economic activity, which are a good indicator of future
growth, are picking up.
In the US, a range of economic indicators also point to the
worst having passed - the decline in industrial production
and the pace of job losses have slowed recently, whilst
consumer confidence has risen.
Equity Markets Rally Strongly
Signs of economic stabilisation provided the catalyst for a
major rally in equity markets during April, a move that has
continued into May. Europe and the Pacific Basin were the
best performing regions in sterling terms, which was pleasing
as we moved overweight in the Pacific region in mid March.
In the UK, those sectors most exposed to the economic
cycle (banks, real estate, industrials) produced the strongest
returns. Not surprisingly, our Alpha portfolio, which invests
exclusively in out-of-favour stocks, produced a return of
20.1% over the month. Our standard UK equity portfolio,
which is more diversified, also outperformed with a return of 10.7%, reflecting our moves into cyclical stocks in recent
months.
The initial euphoria that economic meltdown has been
avoided is now being replaced by a more sober assessment
of the outlook for longer term economic recovery. The
Bank of England quarterly report emphasised that the
pace of recovery is likely to be slow and unpredictable,
as bank lending will be constrained by loan losses and
unemployment will continue to rise for some months to
come. The path of the equity market is thus likely to
remain uncertain over the summer months.
Whilst it may be tempting to “sell in May and go away”,
there are sufficient positives for us to maintain our
overweight position in equities. Price momentum appears
to be bottoming, which has been a good indicator in the
past that a sustainable bull market has been established.
In addition, analysts are beginning to upgrade company
earnings forecasts, as can be seen in the chart opposite.
Corporate Bonds Rally
The recovery in corporate bond prices has gathered pace
in April and May. Even though gilt prices fell in anticipation
of the huge volumes of new gilts to be issued to fund
government expenditure, our bond portfolios produced
positive returns thanks to their corporate bond exposure.
Corporate bond prices have recovered from the collapse
seen last November, but there remain some sectors, in
particular the financials, that remain attractive. We have
recently switched our Tesco bond into HSBC to capture a
yield of 6.8%. On average, we are achieving a yield of 5.5% on our corporate bonds. This yield can also be achieved
on relatively short dated bonds (an average of 3 years
maturity), making this an attractive alternative to bank
deposits.
UK consumer price inflation, after allowing for the cut in
VAT, has remained stubbornly high at 3.8% in April as the
depreciation in sterling has pushed up imported prices.
Although the trend in inflation should start to fall, which
would be good for bonds, there is sufficient uncertainty
for us to maintain our cautious outlook for bonds.
Commodity Holding Re-established
Commodity prices, as measured by the DJ-AIG Index,
have fallen by 46% since we sold out last July. We have
recently bought back into commodities as the prospect
of economic stability and the rebuilding of stocks in China
appear to underpin commodity prices. The oil price has
risen from a low of $35 a barrel to $60 currently as cutbacks
in supply by OPEC have brought supply and demand
closer to balance. Similarly, the copper price is up by 50%
from the lows as mine output has been reduced to reflect
current demand. Those clients without exposure to Alternative Investments should now consider diversifying
into this sector.
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