Takeover activity remains buoyant in the UK and IMF forecasts if reasonable growth levels for 2011, based on confidence in the governments debt reduction plans, were received positively. An increase in risk appetite saw money flow from bonds to equity in September, sparking markets to rally, in particular the riskier emerging and private equity areas benefited the most. Better than forecast figures for ‘out of work’ benefit claims in the US helped drive returns as of course did the Federal Reserves announcement that further quantitative easing (QE) will be deployed should the recovery stall. All this meant the US had its best September for 71 years. The Dollar fell in response to what is being dubbed ‘QE2’ and has heightened the possibility of a currency war between the US and China. In the Euro zone the recovery is still split. Business confidence hit a high in Germany, since June 2007, whereas Ireland announced that its economy shrunk -1.2% in Q2 and Spain’s sovereign debt was downgraded by Moodys. Corporate bond spreads narrowed further as sentiment generally improved alongside expectations of ‘QE’. Despite the positive performance,we reiterate our concern that the big challenges faced by the World’s major economies have not gone away, we remain cautious over the coming months and would not rule out an equity correction.
The UK economy faces the headwinds of tax increases and spending cuts, both impacting 2011/12 rather than this year. The ‘PIIGS’, Portugal, Italy, Ireland, Greece and Spain still have the issue of excessive sovereign debt that needs to be repaid or refinanced, while the emerging market economies have to deal with the opposite issues of strong growth and inflation.
The main change to our portfolios this month was a reduction in Index Linked Bonds, following a strong month and the low real yields on offer we feel now is the time to take profits. We remain reluctant to add more risk given our view that the rewards for doing so are not yet compelling. Although further QE has been hinted at in the UK and US, there is no evidence this will work. In the current environment consumers are de-leveraging, not spending and so pumping more money into the system may only be enough to stop the slowdown, but not enough to stimulate a sustainable recovery. As emerging economies struggle to control inflation we expect QE will add to these pressures if they do not respond. Brazil has already increased tax from 2% to 4% for foreigners buying its bonds. Commodities should benefit at least in the near term from QE and as such we remain overweight, in particular favouring gold and agriculture.
Conscious that UK debt to GDP levels are likely to be high over the coming few years and at levels which have seen other economies sovereign debt downgraded we are still underweight in Bonds despite it having detracted from our performance year-to-date. As for equities, after three years of dividend cuts companies are starting to grow dividends with a year on year rise of 1.6% in Q3. Our exposure is weighted towards Income funds, as we see dividends contributing a larger part of total returns in the coming few years as capital values move sideways. On the whole we remain neutral on equities believing current valuations do not fully reflect the macro economic picture. Our preferred asset classes remain those where reduced and controlled risk are a key consideration and expected returns reasonable i.e. Absolute Return, Hedge Funds, and Infrastructure.