Market Commentary January 2010

In many respects the recession is, to a great extent, behind us. But, as one door opens another one shuts. With consumer price indices creeping upwards, inflation looks to be the factor most likely to concern investors later in 2010. Some commentators believe inflation is set to return in a 1970s style, others do not think inflation is going to be as big an issue as the inflation scaremongers might suggest (but nevertheless, want to keep their options open). As always, only time will tell.

In response to the economic slowdown and financial crisis, world governments have facilitated an explosion in the money supply through quantitative easing measures. Their aim was to reinvigorate credit markets (unfortunately also providing bankers with an open goal for bonus earning). These measures are however, untested and experimental on this scale. While these monetary injections may have had the hoped for effect of avoiding a 1930s style depression, the risk now is that this aggressive monetary policy risks over-stimulating the economy, causing a return to much higher levels of inflation.

Governments are caught between a rock and a hard place as they have relevant, and recent, case history with the Great Depression, and Japan in the 1990s, where governments moved too quickly to withdraw liquidity and the economic recovery faltered before it had a chance to build a strong foundation. The political pressure not to repeat that mistake today is enormous. Inflation has not taken off yet because banks are still reluctant to lend and much of the new money is just sitting around on bank balance sheets.

There are other factors which influence inflation, for example, energy and food costs, the two largest components of CPI calculations. But other factors should also be kept in mind. For example, as the oil price rises, this tends to be passed on to consumers in the form of higher electricity and gas prices. Through 2009, the oil price more than doubled. With inflation measures comparing prices today to those twelve months ago, such large swings have an enormous bearing on inflation levels. Workers seeing that the cost of living is increasing may be encouraged to push for higher wages, adding yet more inflationary pressure. With the economy as weak as it is, and unemployment as high as it is, wage pressures are currently fairly muted. But, as the recovery takes hold increased wage demands will inevitably reappear.

Paying too much attention to whats going on at home risks missing the pressures from abroad. For example, the UKs large fiscal deficit puts sterling under pressure in international currency markets. That influences not just Britains competitiveness abroad but also increases the cost of imports. Likewise, China has been accused of exporting deflation in the form of cheap goods. With its own economic pressures growing, China may have to re-evaluate their currencys real value, in particular against the dollar, with ramifications for inflation rates right across the globe.

Controlled inflation at, say 1.5% to 2% in 2010 might be no bad thing, but if the price of oil and other raw materials continue rising, there is the risk of higher inflation. The worst case scenario sees inflation pushing over 2.5%, anything higher will mean that the Bank of Englands policymakers will only have the blunt instrument of increasing base interest rates in their toolbox, and blunt instruments can do a lot of damage. One thing is for sure - inflation is an issue that is not going to go away any time soon.

EQUITY MARKETS

United Kingdom - Revised numbers from the Office for National Statistics showed GDP had contracted by 0.2% in the third quarter, up marginally from the previous estimate of 0.3%. The upward revision was mainly prompted by a better-than-estimated recovery in construction, although this was undermined by downward revisions in industrial and services output. However, the annual inflation rate accelerated more than economists forecast in November, to 1.9%, the fastest pace in six months. This was driven primarily by fuel and transport costs. Elsewhere, unemployment fell for the first time since February 2008. The Bank of England’s policymakers voted unanimously to keep interest rates on hold at a record low of 0.5% and to maintain its £200 billion quantitative easing programme.

UK equities advanced for a second consecutive month in December as investors grew increasingly optimistic about the global economic recovery, and a bright outlook for demand helped lift commodity prices. The benchmark FTSE All Share Index returned 4.3% over the month. Mid-sized companies, with a monthly return of 4.6%, outperformed their large and small sized peers, who recorded 4.4% and 2.4%, respectively. Most sectors ended positively, indicating broad-based support.

USA - Economic data continued to be mixed in December. The Federal Reserve Chairman warned that the US economy faces "formidable headwinds", a weak labour market and tight credit. However, the unemployment rate fell to 10% from 10.2%, with employers cutting the lowest number of jobs since the recession began. Although the car industry remains on its knees, there were signs that the manufacturing sector was returning to health, as inventories at factories increased for the first time in more than a year, while factory orders also rose by an unexpected 0.6%. In the housing sector, existing home sales rose in November at the fastest pace since February 2007.

The S&P 500 rose in December, ending 2009 with significant gains. Technology stocks fared particularly well and health care stocks moved higher after a less damaging reform bill passed in the Senate. The materials sector also benefited on the back of the general upturn. Industrials stocks gained ground despite General Electric issuing a cautious outlook for 2010. In contrast, financials ended the month lower, Citigroups stock and bond offering attracted weak demand, while earnings estimates for Goldman Sachs Group and Morgan Stanley were lower (though not at the expense of their controversial bonus structures).

Europe - European economic indicators were encouraging in December. The Bundesbank raised growth forecasts for Germany, Germanys GDP is expected to rise 1.6% in 2010, as against the banks earlier prediction of 0% in 2010 and growth of 1.2% in 2011. The European Central Bank revised its GDP forecasts for the eurozone upwards for 2010 and expects economic activity to recover even further in 2011. Data showed that Europes service and manufacturing industries expanded at the fastest pace for two years in November on the back of a recovering global economy. German business confidence increased to the highest level in 17 months in December, sparked by a revival in exports and manufacturing growth. Greece, Spain and Portugal may well have a different story to tell in 2010.

European equities had a solid end to the year, stocks rising significantly in December. Positive data strengthened confidence, materials stocks gained due to rising metal prices, stemming from encouraging growth in industrial production in China. Oil prices were up and energy shares advanced in line, unlike in the 70s OPEC are playing the game. Investors also invested in defensive consumer stocks and utilities firms amid occasional volatility, although telecommunications companies declined in response to broker downgrades. Despite the upward trend, financials performed poorly owing to concerns about new regulations and credit downgrades of some European countries. Greek debt has been particularly downgraded and Standard & Poors warned about the nation’s expanding government deficit. S&P indicated that Spain is only 12 to 24 months behind Greece if the government does not take tough action.

Japan - In December, indicators were mixed, but pointed towards generally robust economic activity in the fourth quarter. Japanese exports to Asia increased for the first time in 14 months. The decline in total export volumes narrowed to -1.5% year-on-year, compared to -13% in October. Industrial production increased for a ninth consecutive month, with forecasts pointing towards a sustained uptrend into the new year. Strangely, confidence among major manufacturers improved for a third consecutive quarter, whilst confidence among retailers, smaller companies and consumers deteriorated. The Bank of Japan implemented further monetary easing measures in a bid to combat deflation and, the Japanese government compiled a ¥7.2 trillion economic stimulus package.

After three consecutive months of decline, Japanese equities staged a sharp bounce back in December, outperforming other developed markets, the broad-based Topix returning 8.1%. Factors that had previously precluded a turnaround in share prices, notably the appreciation of the yen, began to recede and the Bank of Japans announcement of additional monetary easing measures bolstered investor sentiment. Large-cap cyclical stocks and major exporters were the top performers, reflecting a weakening of the yen and signs that US unemployment was close to peaking. In common with other markets, banks and other domestic-oriented names lagged behind.
Far East Ex Japan - In China, economic data confirmed that the upbeat momentum in industrial activity is continuing. The government indicated that it planned to renew its stimulus policy for consumer durables, including cars, to support the domestic economy. Chinese demand for durables boosted exports in Korea, which rose by 33.7% year-on-year in December, compared to 18.1% in the previous month. Manufacturing output again expanded in Korea and Singapore with labour market conditions improving in Australia and Hong Kong. Singapores GDP is estimated to have contracted by 2.1% in 2009, below expectations.

Stock markets in the Asia Pacific region advanced in December, ending 2009 positively. Investors favoured Korean and Taiwanese technology stocks following encouraging growth in overseas exports. Improvement in the global growth outlook for 2010 supported metal prices which, in turn, benefited materials shares. Consumer discretionary stocks surged as more jobs were created, while financials lagged in all major markets in the region (spot the trend ?). Foreign investment inflows drove Indian stocks higher.

Emerging Markets - Many emerging markets are recovering from the recession quickly, and policymakers may soon have to contend with the onset of rising inflation in 2010. South Korean manufacturers confidence is on the rise, as the countrys central bank raised its growth forecast for 2010. Meanwhile, Chinas exports fell by the lowest amount in 13 months and imports surged in November due to resurgent trade with Asian nations (is China really still an “emerging market” ? – discuss). Brazils economic growth in the third quarter was less-than expected, owing to a decline in agricultural output.

Emerging market equities continued to gain ground and, in a reversal of recent trends, emerging Asia and EMEA (Eastern Europe, Middle East and Africa) outperformed their Latin American rivals. Turkish, Chilean, Taiwanese and South Korean equities led returns amid an improvement in industrial activity, boosting investors optimism. In contrast, markets in the BRIC countries (Brazil, Russia, India and China) underperformed the broader index (though still performed positively) . Technology and consumer discretionary stocks were favoured, energy companies, financials and materials were laggards.

Bonds - UK government bonds (gilts) ended December in negative territory as rising equity markets dampened demand for relatively safe fixed income assets. Gilt performance was impacted by a rise in house prices and mortgage approvals and increasing inflationary pressures. After being the best performing fixed income asset class in 2008, gilts ended 2009 in negative territory as unconventional measures and improving economic indicators prompted investors to favour riskier assets.

For similar reasons, European government bonds ended lower in December. Despite the increased appetite for risk and the unconventional measures available from the European Central Bank, government bonds ended the year as a whole on a positive note.

US government debt declined in December and ended the year in negative territory. US Treasuries weakened over the month amid signs that the economic recovery had gathered momentum. US treasuries were the worst performing sovereign debt market in 2009 as the US sold record amounts of debt to fund efforts to bolster the economy and financial markets.

Japanese government bonds continued to advance in December (!) although at a slower pace than last month, as signs of economic recovery in Asia spurred demand for more risk. The Bank of Japan held interest rates near zero while policy makers watch the effect of their lending programme. Elsewhere, the Japanese government proposed exempting overseas investors from paying 15% tax on interest income from corporate bonds, starting 1 June 2010, in a bid to boost inward investment. Form an orderly queue.

Commercial Property - The UK commercial property market continued its recovery, the sector rising by 16.5% over the last six months of 2009, as the combination of an oversold sector and a weak pound made for some attractive deals for overseas investors.

The UK housing market trends continued to show improvement in December. House prices rose by 5.9% in 2009, according to Nationwide, who also said that the rise in prices during 2009 was driven by significant pent-up demand and record-low interest rates. Don’t forget though that residential property fell by 15.9% in 2008, commercial property by 30.1%.

The outlook for residential property in 2010 remains unclear. Although interest rates are likely to remain low, at least in the first half of the year, and generally supportive of the housing market and borrowers, there is still uncertainty over unemployment and whether cash-rich buyers will continue to fuel demand.


CONCLUSION

Things look better now than six months ago, significantly better than twelve months ago, and a world away from the Armageddon scenario of eighteen months ago. But, as always, in the same way that investors should not be tempted to sell what they wish they had sold a year ago, they should not be looking to buy now what they wish they had bought a year ago.

At the risk of being repetitive, for investors who suspect that inflation may be a risk but are not sure of the timing of that risk or of its extent, a well-diversified portfolio still makes sense. Asset allocation flexibility is a key consideration in any investment strategy.