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

October marks the first anniversary of the aftermath of the collapse of Lehman Brothers, and there will inevitably be nervousness surrounding this milestone, in addition to the usual agitations that affect the market in the autumn.

‘Since people started drifting back from their holidays, markets have been a little jittery, and bearish commentary on the economic outlook is still as abundant as more bullish talk,’ explains Chris Iggo, CIO of fixed income at AXA Investment Managers.

Lightning never strikes twice
Of course, there is absolutely no reason why the financial system should suffer another momentous shock, but as Iggo points out, not everything in the financial garden is rosy: ‘Banks are not fully recovered, housing remains weak, bad debts are high and unemployment is still rising.’

F&C’s Ted Scott adds to the skittishness in some quarters, saying, ‘Already, global equity markets have risen faster and further than after any previous market low following a recession. With the market overdue a correction, there is understandably a lot of scepticism about the sustainability of the recent rally.’

A tale of two halves
According to Scott, the rally in the market is a two-stage process. Firstly, shares recovered when it became apparent that the complete collapse of the financial system was unlikely. ‘Until March is was believed that the spectre of debt-driven deflation was a realistic possibility as the economy struggled to cope with the fallout following the demise of Lehman Brothers last year,’ he says.

Scott suggests the massive reflationary response by central banks, not least the Bank of England, contributed to a ‘significant easing of such fears’.

The second stage was the anticipated increase in earnings as companies benefit from the ensuing economic recovery. ‘From around zero earnings growth for the UK market anticipated back in March, the consensus figure is now 20 to 25 per cent growth,’ he enthuses. ‘Admittedly, much of this improvement reflects cost cutting and rationalisation, but the trend is clear.

When profit forecasts rise, analysts tend to underestimate, just as they are usually too optimistic on the way down.’

Rubbish rises farthest first
Investor scepticism is the order of the day though for Scott. ‘Given the rapid U-shaped turn in sentiment, it is not surprising that the cyclical stocks have thus far dominated the market’s rise,’ he says, before warning, ‘In fact, generally, the worse the quality of the company, the stronger its performance.’ Investors would do well to heed this.
Looking back, Scott points out that in the first quarter, the market was especially concerned with the strength of corporate balance sheets, and companies with high leverage saw their share prices decimated. These share prices have rebounded strongly as the financial concerns have been allayed.

‘A good example is the banking sector, which has been by far the best-performing major sector in the rally. There were genuine fears that Lloyds and RBS would be fully nationalised leaving shareholders with nothing, and that Barclays would be forced to go cap in hand to the government. Even HSBC had a major rights issue and cut its dividend. Once the market became more confident about their financial stability, the share prices soared.’

He points to other cyclical sectors, such as mining and industrial engineering, as areas that have also done well, but remains convinced that it is the financially distressed companies across the market that have bounced the most.

Valuations in the market are fair
There is widespread debate about the pace and sustainability of the economic recovery, with the majority agreeing that the economic environment is likely to continue to be a challenging one and that it will be some time before the economy is back on solid ground.

Bob Doll, CIO of equities at BlackRock, says, ‘From an equity markets perspective, there has been some question about how attractive stocks are from a valuation perspective. On the one hand, it would be reasonable to expect valuations to be below average given the severity of the downturn and the high degree of uncertainty over the outlook. On the other hand, however, extremely low interest rates and inflation figures provide support in the other direction.’

Doll and his team believe that equities are fairly valued and that earnings are likely to be the driver of market gains going forward: ‘From a long-term perspective, we think US stocks have the potential to deliver compound returns of somewhere around the 6 to 8 per cent level over the next several years.’

Nevertheless, Doll warns that investors should be prepared for some additional near-term corrective action. ‘Stocks are no longer as cheap as they were several months ago, conditions may be over-bought and there is still a great deal of uncertainty over the outlook. On the upside, there is still a great deal of cash on the sidelines looking to enter the markets, which could provide another jolt to returns’

On US soil
According to Kully Samra, branch director at Charles Schwab UK, ‘The US stock market is forward-looking and investors are seeking the next catalyst to entice additional money off the sidelines. We’ve seen bursts of “panic buying” as investors fear being left behind, and we believe that there could be at least one more burst in store if economic readings continue to surprise on the upside.

‘Although the US$193 billion that has come out of money market funds has contributed to previous bursts, that pales in comparison to the nearly $461 billion inflow into money market funds in 2008 – indicating that there’s still quite a bit of “flight-to-quality” cash on the sidelines.’

But as the global economic recession comes to an end, and markets begin to price in a return to positive profits growth in 2010, the time has come for investors to start to lengthen time horizons and consider how
to rebalance their portfolios.

‘Many equity markets are starting from a position of being cheap within a long-term context,’ explains Richard Batty, global investment strategist at Standard Life Investments. ‘The dividend yield in the UK is currently 4 per cent gross and around 3.5 per cent more than cash. However, the US market is only on a fair valuation with a 2.6 per cent yield. Japan yielding 2 per cent offers good value relative to its own history, but not against other equity markets.’ 

Building blocks
UK property is offering value through its higher yields. However, investors looking at this asset class should be aware of the vulnerability of rental yields as well as capital values, especially in the short-term due to the lack of credit availability. Batty predicts that ‘The average forecast returns of property are similar to the current yield of 8 per cent as rental and valuation falls cancel out any likely inflation gains.’

Over the last century, asset selection has suggested that equities have been the asset choice relative to government bonds and cash as investors have been compensated for holding equities with a high-risk premium. However, Batty suggests that going forward, a more diversified portfolio will be much more effective.

‘Projected asset returns over the next decade indicate that equities should not necessarily be favoured on a “yield-plus-growth” valuation basis, as other assets such as corporate bonds and property offer compelling value and an elevated risk premium,’ he says. ‘Meanwhile, the outlook for global economic growth and corporate cash flow is less dynamic than has been seen historically. As a result, we believe that the nominal returns on assets that compensate investors for inflation, such as equities, will be lower in the future.’

But while equity markets may have limited upside from here on in, and government bonds are at the mercy of the authorities’ attempts to inflate their way to recovery, Simon Thorp, head of fixed income at Liontrust, suggests that conditions may be near perfect for credit assets and, consequently, the demand for credit is likely to continue unabated.

‘The removal of systemic risk from the banking system and the increased demand for credit has had a major impact on both spreads and liquidity. Bank trading desks have finally been able to clear the inventory they built up over the previous 18 months,’ he explains. ‘European investment-grade and high-yield (non-financial) issuance has reached $318 billion since the start of the year, which is 45 per cent ahead of the total for 2008 and more than any entire year on record.’

This is not to say, however, that things are back to normal, but Thorp anticipates two important changes to markets in the post-credit crunch era. Firstly, he expects that corporates will follow banks in issuing senior debt or equity; and secondly, bond market finance will play an increasingly important role in providing liquidity for European companies in place of banks.

He adds, ‘Bond markets in Europe have accounted for 10 per cent of corporate finance needs since 2000, against 31 per cent in the US. Over the medium term, I expect credit to remain the asset class of choice.’

A dash of scepticism
Some warning signs have, however, begun to emerge, suggesting that we may be facing a near-term correction, such as the breakdown in the Chinese stock market, and the possibility that the world is at the forefront of a new interest rate policy tightening cycle (evidenced by Israel’s recent decision to increase interest rates). But, while these are valid concerns, BlackRock’s Bob Doll points out that there are a number of positive factors to consider as well.

‘From a fundamental perspective, economic growth, corporate earnings and credit conditions are all continuing to improve, which creates a more equity-friendly environment. We have little doubt that markets will remain volatile, but as long as policymakers remain focused on the downside economic risks, we expect that the positive factors will outweigh the negatives.’

As markets begin to return to normal volume, after what seemed like a prolonged summer lull, it is Sir John Templeton’s words of wisdom that ring true: ‘Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.’ While the period of great pessimism is clearly over, there remains a large dose of scepticism in the markets and among analysts, fund managers and investors alike.