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

There may be light at the end of the tunnel. Newly installed in his post as chief economist at Henderson Global Investors, following the merger of Henderson and New Star, Simon Ward argues that the group’s Henderson New Star economic indicator suggests that the recession will end at some point this year.

He says, ‘The indicator is less gloomy than the latest Bank of England Inflation Report and suggests that the Treasury’s forecast of a 1.25 per cent rise in GDP in 2010 is achievable. However, a full recovery – in the sense of trend economic growth or higher – will require faster monetary expansion.’

The Henderson New Star indicator estimates the probability of the economy being in a recession three quarters ahead, based on a range of monetary and financial inputs, including inflation-adjusted broad and narrow money supply growth, companies’ liquidity ratio, three-month LIBOR, the yield spread between corporate and government bonds, share prices and the effective exchange rate. It also adopts a somewhat stricter definition of a ‘recession’ than is usually applied – an annual fall in GDP.

Climbing the wall
Ward points out that the indicator’s ‘recession probability estimate began to climb in the second half of 2007 and reached a peak of 91 per cent at the end of 2008 in the wake of Lehman’s collapse. It fell back to 71 per cent in the first quarter of 2009, however, and a further decline to 33 per cent is indicated for the second quarter, using the latest values for the inputs. Allowing for the nine-month lead, therefore, the indicator suggests a two-thirds chance that annual GDP growth will be positive in the first quarter of 2010.’

He adds, ‘The fall in the recession probability estimate has been driven by declines in short-term interest rates and the effective exchange rate and, more recently, firmer real money growth, a rally in share prices and narrower credit spreads. With little scope for short rates to move lower, however, and sterling finding a floor recently, further improvement is likely to depend on stronger monetary trends.’

Little room for manoeuvre
So we are not out of the woods yet. Looking at the prospects for the bond markets, Chris Iggo, CIO for Fixed Income at AXA Investment Managers, explains, ‘The point is that there is little policy flexibility left at the macro level. Interest rates are close to zero.

Fiscal deficits have exploded and the rise in bond yields in the past two months shows that the market could punish any further deterioration in government finances. The focus will have to remain on unconventional policy measures for some time, and that may mean that the Bank of England’s asset purchase programme will eventually be more than £150 billion. That means even more unwinding eventually, and so no flexibility to boost activity through policy for even longer.’

He argues, ‘We have to rely on the market healing itself. The good thing about low interest rates is that it makes holding cash unattractive. This will be even more so if inflation bottoms out soon. While the Bank of England thinks inflation will remain low for some time, we appear to have seen a temporary bottom in the US core inflation cycle, and we have seen a similar profile with UK core inflation.’

Iggo suggests that ‘A lot of people will argue that, because of the rise in spare capacity in the global economy, there will be a decline in core inflation and we have not yet seen the bottom. That may well be the case. But history tells us that inflation is misunderstood, and there has to be a risk that we will not get the sharp deflation at the core level expected by some people. If that is the case, real short-term interest rates are negative, and if that becomes the central view of market participants, there will be more risk-taking, more capital employed in carry trades, higher valuations for corporate assets, fewer write-downs at banks and a quicker economic recovery.’

He concludes, ‘My bet is that history will prevail. Since 1970, consumer price inflation has averaged twice as much in the US as in Japan and five times as much in the UK as in Japan. There has to be some structural reason why inflation has been higher in the Anglo-Saxon economies, demographics being one of them. Even if short interest rates are not negative in real terms yet, they will be at some point, and that will be a major point in the recovery of the economy and housing markets.’

Avoiding government debt
One consequence of this scenario is that gilts seem to be an increasingly unattractive proposition. Christopher Aldous, chief executive of asset allocation specialist Evercore Pan-Asset, suggests, ‘Looking at the current rate of interest earned on a government bond, it does not look like an attractive offer. You can be sure of a capital loss on most gilts if you hold them to repayment, as they currently trade above par value. Can you believe that lending money at two or three per cent is going to pay the pension or make the charitable donations you want in future years? There is risk from inflation, and in due course from the need to put interest rates up.’

Evercore Pan-Asset’s chairman, John Redwood, adds that ‘If you lend your money to the UK government today, you will receive the promise of income at somewhere between 0.75 and 4.5 per cent a year, depending on how long you lend them it for. These are low yields by historical standards. The income from these fixed-income bonds does not grow. If you buy and hold them, you will still be getting the same low rate of interest in two or three years’ time, when the investment world may look very different.

‘Most of the bonds are currently selling above their par or repayment value. If you hold them until the government pays you back, you can be sure of a capital loss. If you want to sell them before they repay, you will make a capital loss if interest rates rise from here. The Bank of England is now, for the first time for some time, more gloomy than many in the markets. The bank has implied that it would keep short-term interest rates down for a long time. In its gloomy frame of mind it is likely to carry on buying gilts itself, keeping longer-term interest rates lower than they otherwise would be. That does not make me want to leap in and buy some.’

Oversupply of gilts
Redwood admits that ‘It is true that the Bank can try to force long-term yields down more, pushing bond prices up, by buying in more gilts at higher prices. However, the more it buys in under the quantitative easing programme, the more it has to sell back if and when it decides to reverse the policy. The Budget book told us that the government needs to sell £220 billion of gilts in 2009-10 as well as £21.6 billion of Treasury Bills. Out of this, it will repay £16.6 billion of maturing gilts and meet its large budget deficit.’

He concludes that ‘All this implies to me that, at some stage, interest rates, both long and short, have to go up again. Clever traders may be able to make some money from a further gilt-edged rally, selling gilts on good days to the Bank and buying them back on bad days from the Debt Management Office. Gilts are only a good deal if you think inflation is going to zero or below and staying there, and if you think the government can sell what it has got to sell without damaging the prices. I think you are better off out of gilts while the government is still prepared to buy them.’

Short memories
So where are investors putting their money while all this uncertainty continues. Alastair Mundy, head of the contrarian team at Investec, characterises current market activity as the Dash for Trash, ‘those companies previously considered most toxic just eight weeks ago now being those most in demand’.

Mundy adds that ‘While some of this bounce-back is the result of some shares having reached hideously oversold levels, there are other equally valid reasons that could be used. The world is, possibly, a better place economically than many thought in March: capital markets have reopened and allowed a number of companies to refinance through bond or equity issues; desperate short covering by “end of the world” investors who had expected many of these share prices to go straight to zero; profit downgrades have stabilised; share prices are on the rise, therefore generating a number of momentum buyers, and a decision by some investors to move more heavily into cyclical sectors, possibly in reaction to reasons previously mentioned.’

He notes that ‘Some share price movements are remarkable, but one could argue that they have only been possible because of the equally remarkable movements in the opposite direction that preceded them. For example, Johnston Press fell from a peak of 360p in April 2007 to 5p in March 2009 before bouncing recently to 40p. Similarly, Punch Taverns fell from over £14 in 2007 to 32p in March 2009 and then bounced to 160p recently. These are just two random examples from a much larger list, but they give a fair flavour of the current reasonably crazy market conditions.’

Going against the flow
But Mundy reminds investors that ‘With markets going up, the sun out and the England cricket team successful, there seems to be considerably more positive spin being put on some fairly unchanged facts. It should be remembered that the West Indies’ presence at Lord’s is soon to be replaced by the mighty Australians. The stock market equivalent could prove equally scary.’

He argues that ‘Clearly, equities are far less attractively valued than prior to the recent 30 per cent bounce in the FTSE 100. However, it is also interesting that a number of those companies that we are happiest to have on a buy-and-hold list have not bounced much. Some defensives, before their most recent rise in the first week of May, were only between five and ten per cent off their lows. We think all of these shares remain very attractively valued.

‘However, the same cannot be said for a number of cyclicals. Even assuming that peak profits are regained and that rights issues are unnecessary, fair value appears to have been reached or exceeded on a number of such shares. Given that peak profits, if recaptured, will be some years ahead, a share price calculated on this assumption needs to be heavily discounted. In addition, given the number of dividend cuts, there is not even the usual high dividend payout to compensate for the wait.’

Rental value
For those looking for a reason to get back into the UK property market, the latest IPD Index of commercial property performance indicates that UK commercial property rental values have hit a 16-year low. Malcolm Frodsham, research director at IPD, points out that ‘British commercial property rental values have been trending downwards for 14 consecutive months on a rolling three-month basis, but rental values haven’t fallen this rapidly for more than 16 years. The demand shock has been so severe, given the breadth of industries affected by the downturn and the scale of companies downsizing, that office relocations and expansions have been off the agenda.’

He adds, ‘The pace of rental adjustment to date suggests that when the wider economy does recover, the UK commercial property market will be well placed to recover from
a low base.’