What Investment looks at the key issues that are driving the investment decisions of analysts and fund managers.

Fund managers continue to warn investors against getting too enthusiastic about false dawns and market rallies.

The upturn in the market at the beginning of the second quarter of the year prompted Julian Chillingworth, manager of Rathbone’s Blue Chip Income and Growth Fund, to observe that ‘The peak of the rally will be marked by maximum enthusiasm, and we believe it has further to run. However, we have already seen a fair amount of profit-taking, some of which has been driven by nervousness ahead of the earnings season.’

But he adds, ‘So far, it has been the higher-risk, cyclical names that have performed well, without any obvious fundamental basis. Certain names will benefit at different times from a bottom in the market, but we believe it is far too early to talk about a basing-out of the global economy, which some of these rises appear to be suggesting.’

Chillingworth says, ‘We are sceptical about the fact that those companies that led the bull market, such as resource plays, will lead us out of this bear market. For the moment, we prefer high-quality defensive names trading on low p/e ratios with good management teams and cash flows, and little operational and financial gearing. However, we are keeping a watch-list of more cyclical names once better entry points are apparent and the economy is showing more of a substantial base.’

Cyclical positives
Not all fund managers, however, are being so cautious. Hilary Aldridge, manager of F&C’s Stewardship Growth and Stewardship Income funds, is gradually increasing her funds’ exposure to cyclical stocks.

She points out that the first quarter of 2009 ‘saw further concerted efforts by the authorities to kick-start the ailing UK economy. Despite this, the UK equity market suffered further losses as the tone of economic and corporate data remained depressed. Nevertheless, it would appear that investors are beginning to rotate out of traditional defensive stocks and into more cyclical recovery stocks in response to an improvement in some leading indicators.’

She adds, ‘Hopes of a much-needed upturn were reflected in the outperformance of smaller companies relative to the larger blue-chips during the quarter. While the beleaguered financial sector remains mired in negative sentiment, the FTSE 100 Index was unable to keep pace. Progress has also been hindered further by a large number of rights issues, as companies used the equity market to raise additional capital to restore their balance sheets.’

Aldridge’s view is that there are more rights issues to come and this will hold the UK equity market back overall. In the light of this, she describes her investment approach as one of ‘pragmatic caution’.

She reports that ‘The shift of investor sentiment at the end of the quarter towards more cyclical shares aided relative performance returns for both funds. We added to our exposure to general retailers before Christmas and holdings, such as Next within our Growth fund and Dunelm in our Income fund, yielded positive relative returns.’

Outlook still poor
Fredrik Nerbrand, head of global strategy at HSBC Private Bank Group, observes that ‘Even though the macro economic outlook is still very poor for the coming quarter, and economic visibility remains limited by the credit market turmoil, we do not believe that the world is likely to go into an outright depression. We believe the globally coordinated fiscal stimulus packages will gain some traction later this year.’

He points out that ‘This should allow the world to escape the most apocalyptic scenario, but the recession is still likely to be widespread and sharp. In this highly risky environment, we believe a focus on wealth preservation is the most appropriate strategy. That said, we believe a frugal approach to risk taking should pay off on a 12-month basis. In this regard, we prefer high-quality credit, which we believe offers attractive value over both equities and government bonds.’

Indeed, Nerbrand argues that the need for governments to issue large quantities of sovereign paper will inevitably have an effect on how that debt is viewed by investors. ‘Increases in government debt issuance should alter the perceived risk-free status of sovereigns. After the initial deflationary pressure from the global deleveraging, we believe quantitative easing and government debt burdens tilt longer-term inflation risks to the upside.’

Interestingly, Nerbrand is also looking at more cyclical stocks within his group’s equity portfolios. ‘We have shifted our equity preferences from a clearly defensive stance to one that favours more cyclically exposed regions and sectors. We also remain focused on the US, which we believe will be the first developed market to recover. However, we acknowledge that the banking and economic crisis will continue. Thus, we expect short-term volatility with the prospect of indices touching new lows.’

Patience is a virtue
Meanwhile, Nigel Cuming, chief investment officer at Collins Stewart Wealth Management, asserts that ‘The risk of selling into these markets continues to rise and, as we have said before, we believe patience will be rewarded. Our asset allocation stance is clearly strategic and that is because we believe equity markets have become mispriced and oversold. That is, we expect markets to correct towards fair value and, as a result, the strategic (and probably longer-term) call on the market means we should position for a rally.

‘In our view, markets are going through a volatile bottoming process that, once completed, will most likely be followed by a meaningful equity rally, in which the upside could prove every bit as spectacular as the fall. While we are confident that equity markets will recover, the timing of these moves is difficult, hence the strategic approach that we have adopted.’

Cuming points out that ‘Markets have always adjusted quickly following recession and the case for recovery is compelling. Equities are as cheap now as they were expensive during the dot-com era. Since 1900, 25 per cent of the first year’s returns have been made in the first ten days of recovery, and 50 per cent of the first year’s returns are made within two months. We remain strategically invested because any equity market rally will prove difficult to chase for those who are not already positioned for it.’

Still waiting for the bulls
Neil Dwane, CIO Europe at RCM, the specialist global equity company within Allianz Global Investors, argues that ‘The recent rally in equities has to be put into context. January and February were a much worse start to the year than anticipated. Hopes and expectations pinned to Obama’s inauguration have been frustrated and markets want to believe that politicians and central banks will effect a reflationary rescue of the current dire circumstances.’

He adds, ‘The market has rallied quite aggressively, and technically it could still rally another three to five per cent, but we do not believe that this is the beginning of the next bull market, because there has not been, as yet, a capitulation-type event that historically signals the bottom of the market.’

Dwane suggests that ‘On a global basis, politicians are starting to put in place better and longer-lasting policies but reflationary plans take time to work. Looking at the stimuli, many EU countries are putting similar amounts of money into infrastructure and other positive developments. It is not just Obama who is building wind farms and high-speed rail links.’

However, he argues that ‘The economy still looks set to be tough. Markets have now priced in a lot of the bad news and the consensus seems to be that there will be a snapback in economic growth in 2010. It seems widely accepted that the worse 2009 is, the faster the recovery will be in 2010. We believe that part of the rallying and ebbing in equity markets will be driven by the fact that markets are still too optimistic about the growth prospects. We would be more comfortable with the image of an extended L-shape into 2010.’

No quick fix
And Dwane insists that ‘Globally, there is no quick fix. However, if a certain level of inflation is factored in, the risk-reward scenario is looking attractive, given the performance of equity markets in recent months. Bond investors are now questioning how aggressive they should be in their buying, when they will be able to buy bonds in the coming months from most governments around the world. Obama is looking to issue US$2.5 trillion worth of bonds over the next few months. From a European perspective, money markets and bond markets presently yield virtually nothing. We believe that income can now be found in the equity markets, with dividends now exceptionally high and valuations looking attractive.’

He concludes, ‘Looking into 2010, growth will begin to reappear, but on a muted level, probably more markedly in emerging markets. The threat of inflation or the threat of bond supply may cause people to worry about financial assets and consider diversifying back into real assets – including equities.’

Property still sliding
Whether or not the green shoots of recovery can be detected in the stock market, UK commercial property returns continue on a downward trajectory. The latest results for the Investment Property Databank (IPD) Index of commercial property fund returns show a fall of 3.1 per cent in capital values during March, a rate of decline consistent with that experienced during the first two months of the year.

Malcolm Frodsham, research director at IPD, reports that ‘Income returns also rose across all sectors, with the all-property average ending March at 0.65 per cent. At the same time, the main driver of movements in capital values is changing. While yields are continuing to rise, the downward pressure on rental values is becoming an increasingly significant contributor to capital depreciation. This rental pressure is manifested in an apparent switch from investor appraisals of future expected cash flows to the cash flow expectations themselves, as measured by rental value growth.’

He adds, ‘All-property rental value growth in March was -1.34 per cent, which implies a more rapid correction in expected future cash flows from commercial property than at any time in the IPD UK Monthly Index’s 22-year history. The compounded capital movement over the first quarter was -8.9 per cent, which, while a significant attenuation from the decline of the final three months of 2008, at -15.0 per cent, is still much steeper than the decline over the same three-month period last year, at -4.7 per cent.’

Longer term attractions
Frodsham argues that ‘Tenants are seeing downward movement in rents quicker than in previous property recessions because leases have become shorter and more flexible, with greater break clauses. While this momentum in falling rents is a concern for property owners, an implied income return of over eight per cent, based on annualising March’s figure, must be whetting the appetite of value- and income-seeking investors.’

Robin Martin, head of research at Legal & General Property, agrees that commercial property does have long-term attractions, pointing out that it has a history of generating rental growth in excess of inflation over the longer term.

He argues that this makes it an attractive option for investors uncertain about the future trend in inflation. ‘Rent offers a different source of income to other asset classes,
which means a well-structured portfolio of commercial property has the capacity to perform better than equities in a deflationary world and better than bonds under an inflationary scenario.’

Martin suggests that ‘Investors can build portfolios that are defensive in the short term, but which naturally convert over time to a point where they can benefit from growth. UK leases tend to be long and generally have upward-only clauses protecting against reductions in rent, making commercial property a robust source of income during economic decline.’