Most asset classes have continued to perform well as global economic data continues to improve, albeit slowly, and despite increasing concern over the state of the finances of a number of Western economies (particularly the EU PIIGS—Portugal, Ireland, Italy, Greece and Spain and also the UK, US and Japan) where massive budget deficits need to be tackled, yet the political will to do so seems weak. This is leading a number of investors to question their holdings of government bonds, which, if they do sell (or refuse to buy) could see interest rates moving higher, as we have seen in the case of Greece, adding to the pressure on already weak economies through higher financing costs. Ultimately this could lead to pressure on equities, although EU help for the weaker PIIGS and, for the non-EU economies, a weaker currency, should see these pressures contained. All asset classes have contributed positively to performance although the equity rally has had the biggest impact in particular from emerging markets. A weaker pound helped boost performance of global funds relative to the UK. Private Equity, one of the biggest casualties of the credit crunch has continued its recovery and has been the best performing sector year to date, up almost 20%. On the other hand Index linked bonds which were one of the best performing assets in the recession have only returned 0.4%. Low yields and concerns over the UK’s credit worthiness has negatively impacted index linkers. Absolute return funds are still delivering positive numbers, although were the second worst sector year to date. The cautious nature of these funds means they underperform when traditional assets such as equity and bonds do well.
Looking Ahead – We remain cautious about 2010 in view of the significant challenges yet to be faced around the world. Specifically for the UK we see a very tough year ahead. Major economic problems and a muddled political scene – current polls pointing to a potential hung Parliament – suggest that the recent pressure on Sterling will persist. As a result we are keen to invest in non-Sterling assets where possible. In Europe, the issue of the Greek (and possibly the Portuguese and Spanish) deficits still need to be answered while the US faces the challenge of further monetary tightening, not to mention mid-term elections. Emerging Markets generally have the opposite problem, namely how to slow down very buoyant economies, although the requirement of higher interest rates and reducing liquidity is similar.
The Chinese curbs on bank lending and the 25bp increase in US interest rates in January saw some weakness in both Bonds and Equities and, although markets have recovered from this, we expect such moves to be a feature of 2010 as further and more aggressive tightening takes place. Hence we remain underweight Bonds and have recently moved our Global Equity weighting to neutral. We continue to be underweight Emerging Markets where valuations look stretched and most vulnerable to monetary tightening, although some markets such as Brazil, Indonesia and Turkey still look attractive due to their positive demographics and returns on capital. Asset classes we unambiguously favour are those where return profiles are still attractive and where we see relatively modest risk, namely Absolute Return, Hedge Funds, Private Equity and Infrastructure.