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

One of the longer-term impacts of the credit crunch on global markets has been the way it has forced professional investors to rethink their ideas on how these markets function. In particular, the notion that stock markets are efficient has taken something of a bettering.

A recent survey of the UK representative body for chartered financial analysts (CFAs), revealed that over two-thirds of its members have abandoned the belief that markets behave in a rational manner. A total of 77 per cent of respondents to a survey conducted by the CFA Society of the UK disagreed with the statement that ‘market prices fully reflect all available information’ and believed that investors don’t behave rationally as individuals. 67 per cent said they believed that investors in aggregate also fail to behave rationally.

Will Goodhart, chief executive of the CFA Society of the UK, observed that ‘The crisis has damaged confidence in the efficiency of the market. It is hard to make the case that market movement during the last year has been the result of rational behaviour at all times.’

Turning to the bond market
So if even the professionals think that markets are behaving irrationally, how should the rest of us be running our portfolios? One increasingly popular solution has been to look to the bond markets, particularly the higher yields available on corporate bonds.

Ben Bennett, credit strategist at Legal & General Investment Management, suggests that  ‘The turmoil of the past year has had a well-publicised impact on corporate bond yields, but it has also changed the way that fund managers assess sector-specific drivers. One particular trend that we believe will develop going forward is that financials should become increasingly sensitive to short-term macroeconomic fluctuations, making financials the new cyclical sector.’

He points out that ‘The corporate bond market is composed of three main sectors: financials, non-cyclical companies and cyclical companies. Pre-crisis, generally speaking, financial bonds were boring, low-volatility instruments. Indeed, in latter years, there was a trend for financials to issue hybrid instruments with equity-like features in order to make yields more interesting.

Non-cyclical companies also issued bonds with low yields given their stable cash flows and high credit ratings, but at least such companies tended to issue bonds with long maturities. Cyclical companies, on the other hand, issued bonds with high yields and therefore provided the potential for significant performance in a rallying market, which, of course, was the general case for many years prior to 2008.

‘The credit crisis and the ensuing recession have significantly altered this sector overview. Yields of non-cyclical companies are no longer uninteresting. Combined with the sector’s long average maturity, significant performance can now be generated by investing in the bonds of non-cyclical companies. Yields of cyclical corporate bonds also increased as the crisis evolved, but the shorter maturities of these bonds have made them less important in the context of high yields elsewhere.’

No real optimism
Taking a broader view of investment markets, Richard Jeffrey, chief investment officer of Cazenove Capital Management, observes that ‘As well as threatening to bring the world economy to its knees, the banking crisis has had two major impacts on the economic cycle. First, it has caused convergence in the cycles of all the major economies. Second, it has caused acceleration in various developments that normally take place over a longer period during the cycle. The latter has been particularly evident in decisions taken in the corporate sector designed to defend cash and to afford some protection against the credit crunch.’

He adds, ‘After a tough start to 2009, equity markets across the globe have subsequently made good progress and have begun to move into positive year-to-date territory. In the period ahead, it is likely that there will be evidence of greater uncertainty in market trends, as real data has so far underperformed expectations and it is likely that some of the more positive hopes for the major economies, expressed in recent weeks, will prove premature.’

Jeffrey feels that ‘The recent rally in equity markets can be regarded more as a recovery from severely undervalued levels, the result of the intense fear provoked by the banking crisis, than as a reflection of real optimism over future developments in the world economy.’

Maintaining a cautious view
What is clear is that many fund managers remain cautious about the strength of the current rally. Ben Wallace, manager of the recently launched Gartmore UK Absolute Return Fund, observes that ‘The stock market’s strong rally reflects growing expectations of an economic recovery. However, some stocks are pricing in a recovery before we’ve had the downturn.’

He points out that ‘As the cascade effects of the credit crisis continue to feed through to unemployment and the broader economy, the market may find it difficult to advance much further. For us, as investors, it will be important to stay nimble and flexible.’ Wallace is currently favouring large-cap companies with genuinely defensive characteristics, such as strong cash flows, growing and well-covered dividend yields and a strong element of ‘self-help’ that can be used to offset the impact of weaker demand.

Paul Niven, head of asset allocation at F&C Management, agrees that ‘Despite the significant rally seen across markets, we still stand some way from pre-Lehman Brothers levels across asset prices and economic indicators, which is being seen by some as a bullish precursor to a ‘normalisation’ of market conditions. Our view, however, is somewhat more cautious in the near term and we feel that investors may now be too sanguine on the outlook for the economy and the risks that remain prevalent.’

He adds, ‘The reality is that a significant amount of uncertainty exists over whether we can generate sustainable recovery beyond the inventory bounce. Our view is that the initial “V-shaped” recovery will give way to an altogether more turgid economic backdrop. We believe it will be some years before the global economy returns sustainably to trend rates of growth as de-leveraging progresses, demand for credit remains muted, access to credit remains relatively low, capital formation is low and consumer end demand is weak.’

Emerging growth
One anticipated consequence of the perceived weakness of the developed markets is a renewed interest in emerging markets. Dr Mark Mobius, head of the emerging markets team at Franklin Templeton, feels that ‘Global money supply is likely to explode. That money is already starting to flow out into the equity markets, and the emerging markets will definitely be beneficiaries of that. There will be a lot of volatility but you must also be aware that these markets will move up as the velocity of money increases.’

Mobius also points out that many of the most attractive emerging markets are also maturing in terms of their economic base. He says, ‘Russia is starting to become a deeper market than just oil and commodities. They have been hit pretty hard by the downturn in the oil price but their reserves are strong and they have a lot of money in a reserve fund. Now they want to focus more on value-added products.’

Mobius predicts that we should ‘expect Russia to move more to the Chinese model, where the government, rather than the oligarchs, will have control of the important strategic industries, and the next stage in both Russia and China is that they need to build up a proper social security and pension system. However, the big problem in Russia is that you need to get a proper banking industry to develop before you can get a proper financial infrastructure.’

Attractive valuations
Martial Godet, head of emerging market investments at BNP Paribas Investment Partners, affirms the attractions of the emerging markets universe. He asserts that the ‘valuation levels of emerging markets have improved alongside the market rally. Emerging markets have now closed the valuation gap between them and developed markets resulting from last year’s relative underperformance, and emerging market valuations are now approaching their long-term average.’

But he cautions, ‘In order to maintain the recent momentum, the “green shoots” in the world economy have to be turned into a real increase in company earnings, in the industrial sector in particular. The risk premium of emerging markets has significantly fallen back to pre-Lehman Brothers collapse levels. This is sustainable only if earning revisions rapidly turn positive.’

Godet concludes that ‘In this uncertain climate, it is more necessary than ever to control risk. Diversification should be favoured, and we still believe that the combination of the BRIC markets is the most appropriate equity investment in the current context, either outright or mixed with fixed income investments to reduce the impact of higher risk aversion which may occur in the future, particularly if the extent of the economic recovery fails to meet expectations or if monetary conditions tighten.’

Dealing with inflation
In the longer term, commercial property will, no doubt, prove to be an attractive asset, especially if inflation rises as an inevitable consequence of quantitative easing. George Shaw, manager of the Ignis UK Property Fund, observes that ‘Opinion has been divided on whether the worst threat to the economy is inflation, caused by significant expansion of the monetary base, or deflation, caused by the fall in demand. But with the Monetary Policy Committee opting to stimulate the UK economy through quantitative easing, investors should be anticipating inflation sooner or later.’

He adds, ‘It is generally acknowledged that quantitative easing is likely to trigger inflation over the medium term, Portfolios with a high, stable and secure income stream are likely to outperform over the next two to three years, which is a benefit that commercial property as an asset class can offer.’

Mixed signals for property
The short-term picture is considerably less enticing. John Redwood of Evercore Pan-Asset asserts, ‘I have been a pessimist about UK commercial and residential property. Values
of commercial property have been falling for months. Commercial rents are weak. There
is a substantial overhang of space. Retailers  have gone bankrupt, leaving empty shops. Considerable new space is being completed in the City when tenant demand is weak.

‘But there are some brighter spots, and there are some buyers around seeking to find bargains now that there has been a sharp fall. Residential prices have also fallen, though less dramatically than commercial prices. Some estate agents now say there is a shortage of supply, and think prices might now stabilise or even rise from here.

‘We need to remember, however, that the existence of some foreign buyers for London property and the existence of some hotter spots within commercial property does not overnight solve the difficult credit conditions, the falling rents and the poor outlook for tenant demand. If the economy grows more slowly this decade, as we fear, and if there is less credit around, we have to adjust to a different level of property values overall relative to incomes.’