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

The general consensus, when considering the future of the UK economy, is that we are finally coming out of what has been described as one of the worst recessions in history, but heading into a recovery that will be long and fragile.

The current problem, says Ted Scott, F&C Investments’ director of UK strategy, is that there is an unusually large range of views proffered by analysts. Says Scott, ‘Some bears maintain that there is still a real risk of deflation, while others believe that the enormous government deficit, combined with the reckless monetary stimulus, will result in high inflation and little or no growth (i.e. stagflation). There are few outright bulls around but, that said, a case can be – and has been – made for a V-shaped or a more gradual L-shaped recovery.’

A bear spectrum
However, Neil Woodford, head of investment at Invesco Perpetual, is more sceptical: ‘I see little reason for confidence, and I do not anticipate meaningful recovery in the next three to four years. The consumer boom was built on easy access to credit, the housing market bubble and the excessive risk and leverage adopted by banks.
‘These massive imbalances were built through the extended boom phase of the economic cycle, and just as they took a long time to build, they will also take some time to address. This has only just started to happen, and it will be a painful and unavoidable process for the UK economy that, in my view, precludes near-term recovery.’
He adds, ‘The perceived “green shoots” that have propelled equity markets higher from their March lows are already starting to look illusory.’

A few canny operators have, nevertheless, benefited from the markets strong uptick. Indeed, according to Standard and Poor’s, the recent fund winners have been those that moved away from a defensive positioning and took on more cyclical exposure at the top of the year. Perfect examples are BlackRock UK Special Situations Fund and the Fidelity Special Situations Fund.

S&P analyst Alison Cratchley, explains, ‘Both these funds owed their above-median performance in 2008 to their defensive positioning, which included an emphasis on large-cap stocks. At BlackRock, manager Richard Plackett increased the FTSE 100 weighting to the maximum 50 per cent permitted. At Fidelity, Sanjeev Shah’s focus on pharmaceuticals and healthcare had also led to an increase in the FTSE 100 component of the portfolio, which peaked at 70 per cent in late 2008.

‘Since late 2008/early 2009 both managers have added more cyclicality to their portfolios. Plackett at BlackRock has reversed his move up the capitalisation scale and has gradually raised the mid- and small-cap component to 70 per cent of assets. Fidelity’s Shah has introduced more consumer-related stocks, taking profits in Reed Elsevier and Pearson in favour of stocks with greater advertising exposure. He has added gaming stocks, such as William Hill and PartyGaming, and retailers like Kingfisher and HMV. He has also increased financials, buying Royal Bank of Scotland, London Stock Exchange and selected REITs.’

Conversely, funds that maintained a defensive positioning lagged both the peer group and the market. Iain McCombie, who manages the Baillie Gifford British 350 fund, a sub-fund of the Baillie Gifford UK & Balanced Funds, reports that, while its defensive positioning was helpful in the first two months of the year, it has proved detrimental since the market rally began in March.

Similarly, the AXA Rosenberg UK Equity Alpha Fund has also lagged behind the market rally. The team responsible attributes most of the underperformance to the fund’s overweight exposure to sectors such as pharmaceuticals and telecoms (and correspondingly underweight positions in financials and materials).

Long-term winners
Looking beyond funds to individual companies and sectors, Philip Dicken, Threadneedle’s heads of European equities, says, ‘Companies with strong financial positions and forward-thinking managements will be well placed to build their market share at the expense of weaker players.

‘In general, we expect the clear sector themes of the past 18 months to give way to a more rational phase in which investor focus switches from buying short-term survivors to identifying genuine long-term winners. Moreover, there is now little to choose between defensives and cyclicals on a valuation basis.  This suggests that stock selection will be the primary driver of performance over the next year. With this in mind, we have moderated the sector positions in our smaller companies funds.’

And Neil Woodford observes, ‘While companies that can deliver transparency in terms of earnings and dividends
have been eschewed by the market during this period, we have seen valuations among economically sensitive groups expand, and this has made the disparity between these sectors unusually pronounced.

‘The companies I am focused on have solid balance sheets and their business models are not geared to fluctuations in economic performance. I believe that excellent value exists in these companies, which typically reside in sectors such as pharmaceuticals, utilities, tobacco and telecoms.’

Woodford argues that these businesses can continue to deliver, despite the economic challenges that lie ahead. ‘Companies in sectors like pharmaceuticals and tobacco are trading on earnings multiples that do not reflect their fundamental qualities.

I believe that their ability to grow profits, cash flows and dividends has been overlooked. But as the scale of the challenges facing the economy becomes clearer, this will change.’

Emerging profits
Among emerging economies, Mark Pearce, fixed income and alternative investment specialist at Threadneedle, believes there are many exciting scenarios from which to pull a trick or two. ‘We believe there are still great opportunities to invest in government bonds from emerging markets,’ he says. ‘Emerging market economies have improved dramatically over the past decade, with many countries holding foreign reserves well in excess of their external debt.’

According to Pearce, the more traditional policies being employed by emerging market governments and central banks have brought stability – and reduced the possibility of default – compared with ten years ago. ‘Venezuela, Brazil and Russia are countries we consider to be strong creditors,’ he says. ‘This means that they have low levels of debt relative to reserves and are in a good position to meet all short-term debt obligations. We are also keen on the dollar-denominated debt of Mexico, which has underperformed in recent months. 

‘Furthermore, large issuers such as Hungary and Turkey are still cutting interest rates, which provides significant upside for bond investors at a time when some segments of the market are questioning whether recent strength has limited the return potential of this asset class.’

A recent poll of wealth managers, carried out by iShares Private Banking, revealed that 43 per cent were confident that emerging market equities will outperform all other asset classes in the next year. Nizam Hamid, head of sales strategy for iShares, comments, ‘Net flows into emerging market ETFs in the current year are almost three times higher than for the whole of 2008 and are outpacing flows into developed market equities.’

Says BlackRock’s Bob Doll, ‘Since the credit crisis began, Europe has been slower to react in terms of policy responses than most other markets, which has created a drag on European economies. Emerging markets have been leading the pack recently, and I believe they will outpace developed markets for all of 2009.’

For 2009, Doll estimates that global growth will be between 0.5 per cent and 1 per cent –  the lowest level seen in the post-Second World War period – and non-inflation-adjusted US growth will be negative, the first such GDP decline in the US economy in 50 years.

‘We expect that GDP will decline by around 1 to 2 per cent in the second quarter, and in the second half of 2009 we are expecting to see growth at around the zero level, probably on the positive side of zero,’ concludes Doll. ‘Economic recovery should become more evident in 2010, but it will likely be a “sub-par” one, with GDP expanding by around 2 per cent next year.’

The spectre of deflation
But Stuart Thomson, economist at Ignis Asset Management, argues that over the next decade UK consumers will experience the dark side of globalisation as deflation spreads from Asia to the rest of the world.

‘The death of deflation has been greatly exaggerated. We expect wage growth to continue slowing as unemployment increases over the next 18 months and the output gap widens further to record levels. We expect nominal wages excluding bonuses to slow to less than 2 per cent by the end of the year and remain in a 1 to 2 per cent range throughout 2010, with the possibility of dipping below one per cent during 2011, when we expect the economy to dip back into recession as monetary and fiscal policy is tightened during the false dawn recovery in 2010.’

The latest CBI pay survey is consistent with this view, with 60 per cent of companies expecting to freeze salaries and recruitment. Wage rises will be less than inflation over the next 18 months, implying negative real incomes.

Thomson concludes, ‘The squeeze of real incomes will be compounded by tighter fiscal policy, exaggerating the impact on real personal disposable incomes. The clear risk for the Monetary Policy Committee is that these lower pay awards become embedded in deflationary price expectations.’