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Comment: Storm in a teacup


Peter Lucas (pictured), Investment Strategist, RBC Wealth Management, examines the factors that will determine the performance of various asset classes in 2010.

The following investment and economic views are those of RBC Wealth Management, British Isles and constitute its judgment as of the date of this publication. These views are provided in good faith, however they do not take into account your own circumstances so should not be relied upon. Seek professional investment advice before making any investment decisions.

The cyclical recovery in equities, commodities and other risky assets has survived its biggest test since March. The news on 25th November 2009 that Dubai World was suspending interest payments on a chunk of its debt served to remind investors of the deflationary risks lurking in the wings. Markets shuddered, but ultimately pulled back from the brink.

Indeed, the turnaround in markets on 27th November 2009 was impressive. (New York was closed on 26th for US “Thanksgiving”.) Equities, bond yields, oil and dollar-yen all lurched lower in the morning, but then retraced these losses through the rest of the day. These large intra-day swings were a sign that the markets wanted to go higher and I went into the weekend feeling relatively confident that the Dubai situation was not going to be a catalyst for a fullblown Global crisis.

I continue to feel that the consensus is underestimating the recovery potential of the global economy, particularly given that companies have yet to rebuild their inventories in earnest and a good deal of the US fiscal measures (tax cuts and increased Government spending) has yet to hit the streets. Furthermore, US companies in particular have been very successful in curtailing costs and the immediate outlook for corporate profits is therefore pretty bright (I have seen estimates for 30% profits growth for the period ahead). In time, this should be good news for jobs and good news for consumer spending. This will also help to allay investors’ concerns regarding about the current level of valuations. Besides, with the alternatives (cash and bonds) yielding so little at present, this is just the sort of environment in which equity valuations could overshoot considerably.

Despite the improving economic backdrop, the bond market continues to behave itself. It appears that purchases by the general public (bonds yield a lot more than cash), by commercial banks (buying bonds as their loan book shrinks) and by Central Banks (parking their foreign exchange reserves) are balancing the increase in supply necessitated by big budget deficits. Bond yields will rise (bond prices fall) when investors have had their fill of bonds, when commercial banks start lending or when Central Banks stop supporting the US dollar. There is a good chance that all three preconditions will be met in the months ahead, but some patience may be called for in the short-term. The longer the bond market remains stable, the better the outlook for risky assets.

The positive outlook for equities stretches into the first and possibly second quarters of 2010. Beyond there, I am less optimistic. Conventional wisdom is that inflation and interest rates will remain low for a very long time. I question this view in two ways. First, as outlined above, I see the economy recovering sooner and sharper than many envisage. Second, I feel that the authorities are placing too much emphasis on ‘output gap’ analysis. The theory is that each economy has its natural growth rate, which is determined by factors like population growth and technological innovation. There is said to be a negative output gap when actual output is below its potential level described by the natural growth rate. Under such circumstances there will be spare resources in the economy and a tendency for inflation to fall. The problem is that output gaps are notoriously difficult to measure. There is a reasonable chance that policy makers are overestimating the level of spare capacity in the economy, in which case the inflation risks are higher than they are allowing for. Elevated equity valuations and higher inflation would not make for a happy mix.

In recent months the monetary authorities have gone out of their way to emphasise that interest rates are going to remain low for a very long time. This is a corner stone of their attempt to reflate the economy. If investors believe that cash returns will be paltry for a long time, they will be more inclined to switch into bonds and equities (thereby reducing financing costs to industry and pushing asset prices higher). Looking at the US yield curve it would appear that they have been spectacularly successful in their endeavours. Short-dated bond yields are back to their lows of the past year (or lower in some cases) and 3-month T-bills yield virtually nothing at all. The irony is that once everyone believes that rates are going to remain low for a long time, the economy will recover and rates will start to bottom out. The low level of short-dated bond yields would suggest we are close to that point.

In the period since 1940 the S&P500 index in America has never traded more than 22% above its 200 day moving average (i.e. its average level of the preceding 200 days). Although the average moves up with the market, it does so very slowly and hence with the index currently at 1113 and the average at 947, the market’s upside is probably limited to 1155 or +3.8%. Not a big move from current levels. However, there was one time when the index did manage to break this barrier. In 1933 the S&P500 rose 56% above the average. Like today, that was a market that was emerging from a major downturn (albeit a 90% decline rather than the 50% decline of 2008/9). All in all, I think there is a good case for sticking with equities, but one needs to keep one eye firmly on the exits

How does all of this relate to the asset classes? Having survived the Dubai scare, equities look well set as we enter the seasonally conducive month of December. Japan’s relative performance versus the MSCI World Index bottomed on 24 November 2009 (the day after my buy note) and has since been boosted by signs that the Japanese authorities will do more to help the economy. The market is so out of favour that any good news will be well received. It’s very early days yet, but the improvement in performance is certainly welcome and encouraging.

My favourite asset class, commodities, has stalled of late, except for gold, which continues to power ahead. With question marks remaining regarding the health of the global economy and with interest rates so low, it is logical that gold is currently the asset of choice for commodity buyers. That will probably change as and when the economy shows clearer signs of improvement.

Government bonds continue to defy gravity, probably for the reasons I have previously identified. However, to my mind all the risks are skewed to the downside and hence I retain my bearish1 rating. Emerging market, Corporate and High Yield bonds should outperform government bonds but doubts remain regarding the outlook for bond prices generally, hence their neutral rating. Inflation-linked bonds have performed well in recent months, but with yields approaching historic lows, I am mulling over the possibility of a downgrade from bullish2 to neutral here also.

The recovery story is entering its final climactic phase. Evidence of improving economic growth will be supportive of risk assets, but the resulting rise in bond yields will provide a considerable headwind. The markets will become increasingly volatile. Eventually, Central Banks and Governments will be forced to remove their support for the economy, at which point markets will relapse. At this stage I see the peak in stock markets coming sometime in the first half of next year, but this view is not carved in stone.

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