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Monthly commentary: November 2010

By November 8, 2010No Comments

SUMMARY  Last week was a very important week, in particular in the context of the Federal Reserve confirming its willingness to keep printing money. As such this commentary is a bit longer than the norm, as there are important themes and possibilities which need to be aired.

The two big investment issues are unchanged: huge sovereign debt in the developed world, and the continuing rise of Asia and emerging markets.

They are linked. The US policy of printing money in the hope that (somehow) it will stir their moribund economy also has repercussions much further afield, in particular pushing Asian and emerging stock markets sharply higher.

In this environment, the portfolio imperative is to navigate these waters with great care. It remains critically important to manage downside risk, yet capital preservation must also be balanced against potential.

The role of the printing presses

As we mentioned last month, the markets have already been anticipating QE2, and this has now happened. The Federal Reserve announced QE2 on Wednesday, in essence printing money to the tune of $600bn.

In March 2009 QE1 was announced primarily to stabilize very shakey financial markets and the global banking system. It worked, and the flood of liquidity also raised financial markets of all kinds around the world.

Then on 24th August this year, with the US economy still in a deep hole, the Federal Reserve announced there would be more QE, QE2. From that point, until the actual announcement last Wednesday, prices of all assets (stock markets, bonds, commodities) continued their recovery from the turbulence of May 2010, anticipating another flood of money finding its way around the globe.

The Fed objective has evolved since March 2009, where claims that we were on the edge of Great Depression II were not hype. Now a key element of their strategy is to drive up asset prices, particularly the stock market, as this will have a positive “wealth effect”, improving confidence, and encouraging consumers and businesses to spend more, which in turn will help employment.

Can markets go higher?

Having to a large extent already anticipated the announcement in the last few days of QE2, can markets go higher still, and if so how much?

Looking at QE2 first, if you join up the dots it is clear that the Federal Reserve accepts the risk of a bubble developing in stock markets (driving them much higher than current levels), and if the “wealth effect” isn’t apparent with QE2, then expect QE3, and so on. Yet much could go wrong. On the one hand there are widespread doubts over whether the “wealth effect” really exists (doubts which we share), and on the other hand much of this new money will find its way overseas, with worrying consequences.

For example, currencies in Asia are being driven up, which hurts their exports, and similarly their local stock markets and commodity prices, creating inflationary pressures. Hence growing talk of “currency wars”, which could ultimately lead to growing protectionism, shaking the global economy and revive talk of Great Depression II.

What about valuations? Stock markets are not particularly overvalued, except perhaps the US, and the outlook for company profits next year is reasonable – there are some extreme opinions which would suggest we are being both too optimistic and too pessimistic, but the truth, as so often, will probably end up in this middle ground. Looking further afield, Asia continues to look attractive, plus emerging markets, particularly India and Brazil. And big global businesses, whether quoted on the UK stock market or elsewhere, not only appear overlooked and good value, but in many instances have chunky, and safe, dividends which are a significant cushion until developed stock markets finally emerge from the torpor of the last decade.

Turning to the technical picture, this tends to provide the clearest lead. For the UK stock market there is clear scope for optimism in the relatively short term, but also clear limits to the optimistic case, which we try and quantify here:

  • Unless the FTSE 100 index immediately falls towards 5400 (it is 5800 as we write), a clear uptrend remains in place from July 2010 (and indeed from March 2009)
  • Conservatively this should allow for the footsie rising to 6200, and more optimistically towards 6600-6800
  • So the optimistic case suggests potential of 10%+ from where we are now over the coming months
  • However, this can only be regarded as a best guess, albeit based on technical indicators which we have found indispensable for many years
  • We do this sort of analysis simply as a benchmark against which to test actual events as they unfold; it is not intended as a recommendation to try and exploit
  • Once this uptrend is exhausted the correction could take us back down towards 4800, a fall of 30% from 6800
  • With everything we know about the current positive drivers of the market and the range of risks, we should not be surprised by the volatility (up and down) implied by this roadmap
  • The above is one possible outcome. No guarantees!

What about other asset classes?

Few clients have much exposure to property, and commodities should still only be at the fringe of portfolios. In the positive short term environment set out above, Asian and emerging stock markets should perform better than the UK, and their stronger currencies will also be a bonus for UK investors.

Other than the latter, the main current exposure in client portfolios is into bonds; investment grade corporate bonds and high yielders, plus global bonds including emerging markets.

Again assuming the positive short term environment, investment grade bonds can continue to improve (though not as much as the stock market), though high yielders will perform closer to the stock market. Global bond funds dominated by a US exposure, may be dull, though more dynamic fund managers, and emerging market funds, should still make money.

What to do?

We have said many times that trying to time the market over short periods is a mugs game, and most people get it wrong most of the time. So the above analysis is set out with appropriate humility.

What you might do now depends more on how you feel than on our analysis. In spite of the potential upside (it is only potential) you might feel quite comfortable still being cautiously positioned, with the prospect of better returns than on deposit.

If you are feeling a bit more confident, and want to take on more risk, there are a few possibilities, for example (these are not recommendations or advice):

  • you can switch out of Newton Global Dynamic Bond and switch in to Newton Real Return. Both funds have an “absolute return” objective, that is they actively look to limit the downside risks (though without any guarantees). The key difference is that most of the performance of the former is derived from bonds, whereas from the latter it is from equities.
  • taking the long view (which we strongly encourage!) while also acknowledging the extraordinary risks in the interim, instead of switching a larger amount into the UK stock market (or the US or Europe), consider switching a smaller amount into, say, India. Looking globally India probably still has the brightest long term prospects, and is not tied into the world economy in the same way as China.
  • drip feed out of a less risky fund (say corporate bond) into higher yielding equity funds over 12-24 months. Such funds might be JOHCM UK Equity, Artemis Income, Sarasin International Equity Income, M&G Global Dividend, Newton Asian Income.

The above ideas are in the context of: short term positives; long term potential in some areas which is already evident; and the continuing unique mix of risks which requires careful navigation and which must not be under-estimated.

Dennehy Wealth