The third quarter saw a number of markets setting positive performance records as global markets moved from concerns about how deep the recession would be to believing that most economies had returned to growth, albeit anaemic. A steady stream of positive economic news (in the West as well as Asia), strong corporate earnings and M&A activity has fuelled the rally with the riskier asset classes leading the way.
Many investment managers, ourselves included, have been surprised by the speed at which corporate profitability appears to be returning as witnessed by the positive Q3 earnings season in the US and interim results in the UK. This has been achieved by aggressive cost-cutting and is also reflected in the high and rising levels of unemployment in the West. However, as we have long warned, a weak consumer sector does not help the long-term outlook for growth once governments start to remove their support packages.
In our view a number of markets and asset classes are trading above their long-term fair value and, while they may overshoot further on the upside in the short-term, there is a growing risk of a negative reaction to any unexpected bad news. The biggest threat we see would be clear signs to the ending of economic stimulus from the various Western governments. For example, evidence that unemployment in the US had peaked and was starting to fall would imply the need to ease the monetary stimulus to avoid overheating by raising interest rates and easing back on spending. Chinese equity markets fell by more than 20% in the summer on the back of their central bank’s attempts to trim spending and while we wouldn’t expect such a big correction amongst the developed markets we are wary at chasing certain asset classes, such as Equities and Index-Linked Bonds, too far.
Specifically for the UK economy we have major concerns over the size of the budget deficit and the implications for tackling this against a very weak political backdrop. We see Sterling coming under further pressure into 2010 and as a result are keen to hold non-Sterling assets where possible.
Our favoured asset classes are those where potential returns remain attractive, such as Absolute Return funds (which aim for a margin over cash returns) and Commercial Property (where yields are nudging 8%), and where there is still some catch-up potential. Hedge Funds and Private Equity stand out in this regard with valuations for the latter having fallen back to 2004 levels and many funds trading at discounts to written down and historic NAVs.