Commentary – Quarterly bulletin, January 2010

31 January 2010

On January 1, we welcomed a new decade as well as a new year.

The old decade will go down in the financial annals as a poor one for long-term investors, with the UK stock market ending the period 15% below where it had started (admittedly that was at the top of a long bull market). However, that may be painting too bleak a picture. Regular savers, investing a constant amount each year on January 1 into the UK stock market, would have accumulated more by the end of the decade than if they had invested the same amounts in cash deposits. They would have done slightly better in gilts than equities but the net difference between these three alternatives is surprisingly small given the financial market turmoil we have been through. (see the first chart) This demonstrates the merits of regular investment or “pound cost averaging,” as it is sometimes called, whereby amidst volatile markets, an investor’s money buys more units when prices are low and fewer when they are high, resulting in better performance than if all units had been bought at the average of the buying prices. Just as diversifying your investments by asset class is a sound strategy, so too is diversifying your points of entry to the markets.

Turning to the more recent past, there has been little change in the investment landscape since the last commentary.

We have seen further evidence that the global economy is bottoming out and in some recession-hit countries output has already picked up. In the last quarter of 2009, the UK recorded its first positive quarter since the start of the recession, although the first estimate was only just positive and this data series can be revised significantly for years afterwards. We cannot yet be sure that the recession is over. The investor consensus (as reflected in the markets) is still favouring a benign economic environment for the next few years, during which the global economy continues to recover and eventually does so without inflation threatening to rise much above central bank targets. In this scenario, the policy stimulus measures would gradually be withdrawn, including a return of interest rates to more normal levels, without any significant market impact.

The risks to this rosy scenario are still high.

Although it is not unreasonable to accept the consensus view as a central case, there are several risks that investors should be aware of and, if possible, protect themselves against. Today’s consensus scenario suggests that the right asset allocation strategy is to be overweight equity-type assets relative to bonds. However, if the consensus shifts to anticipate renewed economic decline then equities are likely to underperform bonds, and possibly cash, for a while. This could happen if evidence builds that the private sector is failing to take over from the fiscal and monetary stimuli as the main engine of future growth.

A weaker economic environment could be associated with either deflation or high inflation, although the latter is less likely. Given the amount of spare capacity in the global economy, renewed economic weakness could well give rise to deeper and more persistent deflation than we have had so far. ‘Risk free’ government bonds should perform exceptionally well in these conditions. The high inflation scenario could be triggered by policymakers attempting to withdraw the monetary stimulus too soon or as a deliberate government initiative to reduce its debt burden in real terms. Were investors to anticipate such a scenario, fixed-coupon bonds would fare badly, and possibly worse than equities, leaving cash as the best performing asset class of these three.

It is difficult to position portfolios to do well across all scenarios. However, it is prudent in these uncertain times to include some investments which provide a hedge against a change in the prevailing consensus view. It is also important for investors to be able to react quickly should such a change become evident.

Equity markets have faltered again recently but should continue to trend higher.

After rising by about 50% from their lows last spring, it is unsurprising that the pace of increase is slowing. Markets, as always, move in anticipation of a change in the economic environment, and this time they were helped along by dramatic monetary stimuli. The monetary environment is still extremely conducive to further gains in equity markets but investors are anxious to see some evidence to support this before committing themselves to further exposure. Essentially, as the public sector’s fiscal and monetary stimuli fade, the private sector needs to take up the running. This will to a large extent depend on consumer behaviour. While waiting for evidence there could well be some volatility in equity markets, but I would not expect dramatic weakness. I take comfort from the lagging relationship between interest rate movements and the level of equity market volatility. There has historically been a period of about two years before a change in the direction of interest rates has a big impact on equity market volatility, as demonstrated below in the US market. So, even if interest rates start to rise soon, equity market volatility should stay down around current levels for at least another year.

‘Risk-free’ government bond yields have been edging up.

Investors are paying more attention to sovereign risk these days. For countries, such as the UK, running large public sector deficits and steadily building a debt mountain, the yield demanded by investors to hold this debt is starting to climb. The gap between the 10-year gilt yield and its German equivalent is approaching 1%, having been below zero in March 2009. While the risk of outright default by the UK government is virtually nil, there is a risk of inflation devaluing the coupon and capital repayment. Corporate bond yield spreads (the premium over government bond yields for extra risk and poorer liquidity) have continued to shrink. But the shrinkage, at least in some sectors of the market, is now insufficient to offset the rise in government bond yields so that corporate bond yields, too, are rising. We may well see more of this as the year unfolds.

— Ken Forman

Ken is an investment business consultant who spent 30 years as an analyst and portfolio manager at Standard Life Investments.