October 2009

Investment Prospects

Summary

• The economic recovery is sustainable. We do not expect a “double-dip”.
• Bond market returns are likely to be modest in the coming 3 months, though the risks are low.
  
• Equities still have considerable upside in this cycle and it is too early to take profits.
  
• Nevertheless, be prepared for a period of equity market consolidation.
  
• Alternative investments offer plenty of scope for positive returns, especially property.
  

Review of Recent Events
Record Rise in Equities

A progressive improvement in the global economic outlook over the third quarter produced the strongest three-month return from equities since the 1970’s, with the UK market up 22% in the period. At the start of the quarter our key measures of value and momentum both indicated close to maximum opportunity for global equities, so we positioned portfolios overweight in this asset class and benefited in full from the rally. Almost all portfolios outperformed their benchmarks during the quarter as a result.

The stabilisation of the banking sector and the commitment of the central banks to underwriting the recovery through low interest rates and quantitative easing provided the background to a recovery in confidence around the world. China played its part early in the cycle with a huge boost to infrastructure spending, whose effects have rippled through all the industrialised countries. By the end of the quarter, consumer spending was in general stronger than expected, in spite of rising unemployment, and forward-looking business surveys were pointing to growth in services and manufacturing in all the major economies.

The biggest beneficiaries of this stage of the recovery were those sectors that had underperformed the most previously - banks, mining and real estate. Additionally, those stocks geared to the economic cycle continued to produce exceptional returns, reflected in the performance of our contrarian “Alpha” portfolio, which was up 31% over the quarter and has risen by 45% so far this year, outperforming the FTSE 100 by 30%. Our standard equity portfolios also outperformed, but to a less exceptional degree, due to the tight risk controls in place. Our UK equity portfolio outperformed as our focus on undervalued shares worked well in this recovery environment.

International markets produced mixed results. Europe was the best performer, reversing the extreme oversold position in the previous period. By contrast, the Japanese equity market actually fell by -2% over the quarter as strength in the yen was seen to threaten the recovery in the important export sector. We had very little exposure to Japan over the period, having reduced our position in March on concerns the strong yen would depress exports. Stock markets in the Pacific Basin region also lagged, as the pace of economic recovery did not match previous market gains.

Currency Gains

International equity performance was enhanced by gains in all the major currencies against sterling, as can be seen on page 3. This reflected expectations that UK economic growth will lag that of the US and Japan and the fact that UK real interest rates are relatively unattractive, being now the lowest amongst the major currencies.

Bonds Rally

Government bond markets were pulled between concerns that quantitative easing would lead to runaway inflation on the one hand and that protracted low economic growth would produce deflation on the other. As the quarter progressed, the deflation camp came to the fore as it became apparent that the huge excess capacity in the global economy would prevent inflation from taking hold in the near term. UK government 10 year bond yields fell to 3.6% as a result, for a total three month return of 1.1%.

Corporate bonds benefited from the improved economic environment as default risk on investment grade bonds declined, continuing the trend of the previous quarter. Highly rated bonds, such as the utility company RWE, saw their yield fall from 2.1% above gilts to just 1.1% above, for a total return of 4.7% over the quarter. Returns on lower credit names, such as the insurance company AIG, achieved double digits over the same period. The gains have been such that corporate bond yields are now back to the level last seen inJanuary 2008, well before the financial crisis at Lehman Brothers appeared on the horizon. We maintained a substantial overwieghting in corporate bonds over the period and as a result outperformed the benchmark by more than 5%.

Alternative Investments

Commercial property appeared to reach a turning point during the quarter, even though rents continued to fall. Since the start of this year investors have been eyeing the opportunity to buy into property on attractive valuations and the tipping point seems to have been reached. The IPD property index turned positive in July for the first time in 2 years and there are signs that life is returning to the market. We purchased the Aviva Property Trust in early September and have seen a 6% appreciation since then.

Commodity markets have seen varying returns, with copper up 20% as China rebuilt its stockpiles whilst oil was unchanged at $69 per barrel. Overall, commodities produced a 3.5% return, reflecting the positive growth outlook for the world economy. Our commodity fund underperformed by 5% over the quarter.

The hedge fund index was up 9%, a modest return given the correlation that we have seen in the last 18 months between hedge funds and equity markets. Our hedge fund produced a return of 10% for the quarter, gaining from being overweight equities and bonds.

Finally, our Deposit Alternative portfolio continued to generate returns well in excess of deposits after all fees.

Market Outlook

Interest Rates & Currencies

The consensus forecasts shown above for 2010 do little to inspire confidence that a sustainable recovery is underway. Of the developed countries, only the US is forecast to achieve growth close to the long term trend rate next year. It is not surprising therefore, that many forecasters predict a renewed downturn as unemployment rises, taxes increase to pay off debt and bank lending is constrained by property losses.

Our view is more positive and we expect growth forecasts to be upgraded in the coming months as
the recovery gathers momentum. Record low levels of interest rates provide a huge boost to consumer purchasing power as is evidenced in robust retail spending and consumer confidence in both the US and the UK. Whilst unemployment is rising, the pace of deterioration is now slowing and the projected increase is unlikely to tip either economy back into recession.

More significant is that industry is refinancing itself through the capital markets, circumventing the banks, which are still slow to lend. The quantitative easing programmes, which both the Federal Reserve of the US and the Bank of England are likely to continue into next year, means that such refinancing can be effected on attractive terms, allowing companies to take advantage of the re-stocking cycle that is in its early stages. In addition, although the “cash for clunkers” car purchase
schemes may be coming to an end, a large proportion of the additional government spending plans in the major economies, such as on infrastructure, will continue into 2010.

We expect these powerful stimuli to underpin the recovery, as is reflected in the forward-looking business surveys which point to expansion in all the major economies. Clearly, there are many uncertainities and for this reason we expect interest rates in the US and

the UK to remain at current levels until at least the middle of 2010.

A further support to recovery should come from depreciation in the US dollar and sterling. It appears that Japan and Europe are prepared to acquiesce to a further devaluation in the dollar in an effort to revitalise the engine of world growth, the US economy. Sterling is also being talked down by the governor of the Bank of England, justifiably, as sterling is still overvalued against the dollar on a purchasing power parity basis. With large surplus capacity in the UK economy, there is little chance that further currency depreciation would lead to higher inflation, so this is an
attractive policy option.

UK Bonds

Although higher inflation appears a remote prospect in the current weak growth environment, the risks for the UK bond market are nevertheless rising. As the chart above shows, real (i.e. after inflation) UK bond yields remain close to zero, making them fundamentally unattractive. If expectations for economic expansion start to improve, concerns that inflation will rise will surely follow. At this point the Bank of England will have to reduce its bond holdings to withdraw the excess monetary stimulus of the past year. Already price momentum is extended and sending a warning signal that a reversal is possible. We already have a defensive position in government bonds, but if the recovery evolves as we expect then we will take additional steps to lock in the gains of the past two years.

Corporate bonds now offer less protection against a rise in government bond yields as the yield premium has declined dramatically, as explained on page 2. Whilst some financial sector bonds still offer attractive value, the big gains have now been made on corporate bonds as a wall of money has chased a limited supply over the past six months. We will continue to seek out attractive opportunities, but the gains will be smaller.

Global Equities

Equity markets have now rallied around 50% from their low point in March. A move of this magnitude, coupled with clear signs that the worst of the economic downturn is behind us, indicate that a new bull market is most likely underway. The chart of price momentum below shows that whilst perhaps two thirds of the initial rally has been realised, this cycle has considerably further to run if history is any guide.

After a 50% gain though, it would not be surprising to see a period of consolidation, which raises the question of whether we should take profits on equities in the short term. Over the next three months we think it unlikely there will be sufficient economic disappointment to justify the costs, and risk, of reducing equity exposure now. Better instead to remain overweight equities, particularly as bonds appear unattractive, but switch out of those markets that have become relatively expensive.

The chart opposite shows our favoured measure of value, cash flow yield, for the UK stock market. UK equities are no longer outstandingly cheap now that share prices have rallied and company earnings have fallen. However, UK shares are still on the cheap side of fair value, so they remain fundamentally attractive. European and Japanese equities are similarly reasonably valued, whilst the US and particularly the Pacific Basin markets, have become expensive. The Hong Kong stock market, for example is now up 95% from its low point and its cash flow yield has fallen to just 4.2%, from a high six months ago of more than 10%. As a result, we are now looking for a suitable opportunity to switch our remaining Pacific Basin exposure into Japan, where both the stock market and currency offer more upside potential.

Although valuation in most markets may now be back to more normal levels, the bull cycle for equities should be prolonged by increases in company earnings. The table on page 6 shows how rapidly earnings are expected to grow next year. The early stage of recovery is the most potent for earnings as revenues expand whilst labour and other costs remain at reduced levels, producing high productivity. Already, we are seeing this with a recent jump in US productivity data.

The greatest risk to the ongoing recovery in share prices is that interest rates are raised too soon. At present, this is a distant prospect in the UK and US (the Centre for Business and Economic Research does not expect UK interest rates to return to 2% until 2014) although we have already seen rates being raised in the more resilient Australian economy. In the UK,

however, the desire to raise taxes next year to reduce the huge burden of government debt is likely to mean that the Bank of England will delay any increase in interest rates until there is clear evidence of a pick-up in inflation. This should mean that the equity rally can be prolonged into next year before economic policy changes start to hamper the pace of company earnings growth and the outlook for equities.

As the chart below shows, analysts are still upgrading forecasts for company earnings, a further positive indicator for the UK stock market. In the US, by comparison, we have seen a faltering in the pace of earnings upgrades, another reason to restrict our US equity exposure to no more than a neutral weighting.

Over coming months we also see scope for sterling to weaken against all the major currencies and on balance this will boost the earnings of UK companies. It also makes it attractive to hold international equities, to benefit from currency gains, and hence we remain overweight international markets with a bias towards Europe and Japan.

In conclusion, price momentum, valuation and the direction of company earnings growth all point to further upside for equities for the time being.

UK Stock Comments

The best performing market sectors over the third quarter were mining, financials and property. We had moved into property through the purchase of a holding of Land Securities in March of this year and the shares produced an 11% outperformance during the period under review as the commercial property market was seen to have bottomed.

In the financial and mining sectors we maintained a weighting close to that of the overall market after taking the view that both sectors were particularly vulnerable to adverse events. We were, however, overweight in the insurance sector, which produced the strongest returns within the financials.

The weakest performing sectors were in the traditionally defensive areas of consumer goods and
pharmaceuticals. Whilst we had avoided the expensive consumer goods sectors, we did have exposure to the more attractively priced pharma companies. These provide some protection for the portfolio in the event that the economic news takes an unexpected turn for the worse.

As the cyclical areas become more expensive (we have recently sold the engineering company, Charter International, out of the Alpha portfolio) we will look to move into the more attractively priced shares in the defensive sectors and also in those companies that typically perform well later in the cycle. This includes construction and media stocks and those companies that are highly leveraged but which are now able to refinance themselves on attractive terms.

Alternative Investments

Commercial Property

The graph below shows that property values have started to move up again after a 37% fall. The upside potential in the near term, however, is constrained by falling rents and an overhang of non-performing loans held by banks secured on property. At present the banks want to avoid realising losses, which would damage their capital ratios, so little property is coming to market. However, as the banks’ financial position strengthens, so they are likely to release more property for sale. Nevertheless, there is considerable pent-up demand for property investments so we think a double dip is unlikely. For this reason we have re-invested back into commercial property in September.

Commodities

Commodity prices in general have been driven higher by the re-stocking of industrial metals in Asia and by increased demand for precious metals as an inflation hedge. Stocks of industrial metals are now at levels that suggest a period of consolidation is likely. Precious metals, in contrast, could rise further in view of the ongoing threat to inflation of quantitative easing.

Energy prices remain under downward pressure as economic growth remains remains below trend and stocks are relatively high.

Agricultural prices have in general weakened over the past quarter but Schroder’s projections now are for an increase in sugar, coffee, wheat and corn prices in the current quarter, based on seasonal and weather factors combined with low inventory levels.

On balance, the outlook is sufficiently positive for us to maintain our neutral position in commodities.

Hedge Funds

Our Valu-Trac hedge fund uses a combination of value and momentum indicators to systematically take both long and short positions in a wide range of financial and commodity markets.

At present they are in the process of reducing their long position in precious metals but retain long positions in agricultural commodities. They have long positions in both bonds and equities, based on positive momentum, but have short positions in sterling and the US dollar. They are showing positive returns for the current quarter.

Matthew Hunt 0207 392 2811
13-15 Folgate Street, London E1 6BX
T: +44 (0)20 7392 2810 F: +44 (0)20 7247 6169

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“The information in this document is believed to be correct but cannot be guaranteed. Opinions and forecasts constitute our judgment as at the date of issue and are subject to change without notice. Certain investments carry a higher degree of risk than others and are, therefore, unsuitable for some investors. Before contemplating any transaction, you should consult your financial adviser. The research and analysis in this document have been procured, and may have been acted upon, by Prospect Wealth Management and connected companies for their own purposes, and the results are being made available to you on this understanding. Prospect Wealth Management, its clients, officers and connected companies may have a position, or engage in transactions, in any of the securities mentioned. Neither Prospect Wealth Management nor any connected company accepts responsibility for any direct or indirect or consequential loss suffered by you or any other person as a result of your acting, or deciding not to act, in reliance upon such research and analysis. Past performance is not a reliable indicator of future results.”

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