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

It will come as little surprise to those investors who have been buffeted by one of the worst years for stock market investment on record that the best returns over 2008 were achieved by investments in fixedinterest and commodities.

The unprecedentedly low level of interest rates now confronting UK investors will only make bonds look more attractive, argues John Pattullo, co-manager of the Henderson Strategic Bond and Henderson Preference & Bond funds.‘Even with interest rates in the UK now standing at just 1.5 per cent, there is still further scope for the monetary policy committee (MPC) to copy the US Federal Reserve and take the base rate closer to zero. If this happens, the UK’s legion of savers and pensioners will be up in arms about the erosion of their income, just at a time when they need it most.’

An alternative to cash
He points out that ‘According to Moneyfacts, more than three-quarters of savings account providers cut their savings interest rates following last month’s base rate cut.The expectation is that they will do something similar following this latest downward revision. Some high street savings accounts are now reported to be offering interest of less than 1.0 per cent.Why bother?’

Pattullo reports that savers are already taking a greater interest in bond funds as a result of the derisory returns available on cash: ‘Retail inflows into our funds suggest a “sea change”in investor appetite, and the beginning of a significant trend in favour of fixed-income assets. Investors who don’t want to miss the boat should consider adjusting their asset allocation in 2009, moving out of the “no man’s land”of cash and into fixedincome
funds that are offering attractive yields.

For example, the Henderson Strategic Bond Fund has a current yield of 8.8 per cent and the Henderson Preference & Bond Fund has a current yield of 9.7 per cent.’

He adds, ‘We believe that, at present, the “credit spread” within investment-grade corporate bonds is where the real value lies, and our portfolios are well positioned to capture this. Therefore, investors looking for a more rewarding home for their savings should consider locking into the compelling yields currently available, in order to continue to reap the rewards over the long term. Given our concerns over excessive supply, we remain cautious on the government bond market, and it is still too early in the cycle to be favouring high-yield bonds.’

Too much risk in equities
Chris Iggo, CIO fixed income at AXA Investment Managers, sees more of the same for 2009: ‘Capital preservation should continue to be the key driver, which in a way rules out a significant increase in exposure to equity markets. Stocks are cheap on most traditional valuation metrics, but corporate earnings will continue to decline and corporate management is being more bond-holder friendly than equity
investor friendly.’

He suggests that ‘If credit conditions remain tight, companies need access to the capital
markets, so they have to do what corporate bond investors want.That means prioritising interest payments over dividends.The yield on investment-grade corporate bonds – at the market index level – is around seven per cent, compared with gilt yields of under four per cent. This could set up an outperformance of corporate credit over government bonds this year.’

As far as commodities were concerned, it was gold that emerged at the head of the pack, with returns boosted by sterling’s weakness for UK investors, although even these markets were not immune from increased volatility.Nicholas Brooks, head of research and investment strategy at ETF Securities, points out that ‘ETFS Physical Gold has been a particularly strong performer, with 2008 returns up four per cent in US dollar terms, marking the eighth consecutive year of positive returns, and up 44 per cent in
sterling and 11 per cent in euro terms. In 2009, safe haven assets such as gold, and less economically sensitive commodity sectors, could see the strongest flows, although our platform of oil exhange-traded commodities (ETCs) has seen $435 million of inflows over the past nine weeks as oil has traded in the $40 to $50 range.’

He adds, ‘Commodities have generally weathered the financial storm better than their equity counterparts, with the DJ-AIG Commodity Index 3 Month ForwardSM down 30 per cent last year compared with a 42 per cent fall in the MSCI AC World Index.

Over the longer term the outperformance of commodities has been more pronounced, with DJ-AIG Commodity Index 3 Month ForwardSM up 70 per cent and 272 per cent over five- and ten-year horizons.Over the same periods, the S&P 500 is down ten per cent and 13 per cent respectively.’

Pressures on Obama increase
So what is the outlook for equity investors? In the US, the Obama presidency is off and
running against a background of continuing economic turbulence. Simon Laing, manager of Newton American, observes that ‘Unfortunately for Obama, the global economy has deteriorated significantly in the period between winning the election and his inauguration. His election has had an inspirational effect on people and world markets to the extent that he has a lot expected of him, but we continue to believe Obama has an enormous task ahead of him in 2009 in trying to stabilise the US economy, the financial system, housing and unemployment.

‘The sheer scale of these issues will dominate his policy and media through most of 2009, and it will probably only be in the second half of his term that non-economic issues can climb up the ladder of importance.Obama has assembled an excellent team around him and has already given indications of what to expect with his massive fiscal stimulus plan. However, we are in unprecedented times and so nobody can say for certain whether his policies will work.We think he is heading down a better course than the previous administration and hope his actions are the right medicine for this very sick patient.’

Ageing American infrastruture
One area of the US economy that could benefit from the new policies is the development of infrastructure projects.Nick Ford, a US equities fund manager at Scottish Widows Investment Partnership (SWIP), says, ‘We welcome Obama’s plan for investment in US infrastructure and believe that the proposed economic stimulus package will kickstart
much-needed investment in infrastructure. However, the state of the economy will slow infrastructure spend in the near term, regardless of the fiscal stimulus that Congress may supply.

He adds,‘However, the investment tap will not be turned off because the US needs
to invest in capital equipment in order to ensure the economy recovers over the long term.This will provide opportunities for US companies providing materials and services for power, highways, bridges and water supply, all of which will need upgrading over the coming years.’

Underlining the urgency of this policy, Ford asserts that ‘regardless of politics, US infrastructure is starting to creak. There is a lot of ageing equipment that was built in the
1940s and 1950s, which requires muchneeded investment. This is a theme SWIP has been looking at for some time now and our portfolios are set up to benefit from the current economic scenario, whether or not Obama’s plans are successful.’

His colleague, Simon Moss, reports, ‘We are looking at companies such as Quanta Services, which manufactures products for the transmission of electricity. The US equivalent of the national grid is looking to outsource a lot of its work when upgrading the system.

Companies such as Quanta will benefit from long-term investment in one of the world’s
largest electricity supply lines. On the flip side, we are more cautious on consumer stocks as our analysis concludes that capital spending will provide the largest stimulus for the US economy, not consumer spending.’

Valuations attractive, but not irresistible However, given the relentless downward surge in equity markets in the second half of 2008, logic would dictate that some valuations, at least, are now extremely attractive. Indeed, Sanjeev Shah, portfolio manager of Fidelity’s Special Situations fund, argues that ‘With markets down some 40 per cent from the peak and sentiment reaching historic lows, this has provided a very good stockpicking environment.’

He points out that ‘The rising spread in valuations between sectors and within sectors is creating a great bottom-up stockpicking environment.We may not have passed the trough for stocks yet, and the economy is likely to be in recession for some time, but analysis of fundamentals leads me to be more optimistic about stock market opportunities than I have been for a while.’

In particular, Shah highlights the fact that ‘More directors have recently been buying their own companies’ shares than at any time in the past year. That they have been doing so in a falling market is doubly significant. Analysts are becoming more realistic and lowering their forecasts. Valuations on many stocks and sectors are looking attractive when compared with those in the 1993 bear market, especially on a price-to-book basis.’

He reports, ‘In this environment, I’m increasing my exposure to financials with a basket of banking stocks to spread the risk. I also like other non-bank financials such as Provident Financial and I am overweight financials overall.

‘I have increased my exposure significantly to consumer cyclicals, particularly media, leisure and retail stocks, which look very attractive versus history and are under-owned. British Sky Broadcasting and Pearson are large positions in the fund. I continue to have large exposure to structural growth stories that look good value such as business services company Xchanging, which benefits from business process outsourcing trends. And I am also overweight technology stocks.’

Small-caps will survive
Focusing on small-caps, Gervais Williams, manager of Gartmore Growth Opportunities, believes that UK small-cap stocks have the potential to rally strongly as investors seek to rebalance their portfolios back into recovery stocks. ‘Some earnings downgrades have already come through and the market is anticipating many more. However, as these downgrades filter through, many stocks are seeing recovery buyers and few sellers.’

He asserts that ‘The patient is alive. Many of the stocks we are looking at could double from here and still look undervalued in terms of their future earnings. I would expect that sectors currently under-owned by investors would be among those that recover the most
and I have raised my exposure to small-cap oil stocks over the past month, after valuations reached overly depressed levels.’ 

Williams says, ‘Already, we’ve seen oil bouncing strongly off its December lows and it could have further to go.We started a new position in Heritage Oil during December and we’ve added to our existing positions in Dragon Oil, Petroceltic International, Sterling Energy and Salamander Energy.’