Economic & Market Update - January 2010

During the second half of 2009 economic recovery finally got under way in most of the world’s major countries following one of the deepest financial downturns witnessed in the past 60 years. 

In the developed western economies the upswing has been assisted by injection of capital by central banks (government funding) in addition to the near-zero interest rate policies. The key question for 2010 is therefore whether the recovery in household and private business sectors will be strong enough to enable the authorities in each country to start to withdraw the aforementioned financial stimuli, without creating renewed economic weakness. 

On the surface, it might seem that all the ingredients are in place for a healthy recovery in 2010. After all, central bank interest rates are still at extremely low levels, bond yields and corporate bond spreads have fallen considerably, share prices have rebounded, world trade volumes are recovering, and house prices are stabilising or recovering in the majority of the developed world. Furthermore, employment has shown signs of stabilising and inflation is low or falling in many countries, allowing central banks and governments to continue with their stimulus programmes. 

In order to continue this upward momentum however, households and financial institutions need to continue to pay off debts (deleveraging), and raise their savings or levels of capital. For households this implies that consumption (spending) is likely to remain restrained until their finances are restored to good order. Equally, investment into business and the hiring of staff has been cut back sharply in many economies and is unlikely to resume previous peak levels until final demand returns to a more normal and sustainable growth path. With low rates of spending or revenue growth, the problems of indebted corporate or even sovereign borrowers like the Dubai World’s Nakheel are being exposed. 

The low level of interest rates in many countries is not necessarily a sign of ample funds being available. On the contrary, although central banks are making funds available to banks, these funds are not reaching the broader users of funds – households and companies – as banks are reluctant to lend and borrowers are unwilling to extend their indebtedness. 

Therefore most economists are predicting only moderate rates of economic growth with continued low inflation in 2010, particularly in the UK, US, Spain and Ireland. By contrast, in the emerging world there are only a few economies where such constraints apply (e.g. Eastern Europe and the Baltic states), as much of the emerging world is generally not subject to the same debt-derived growth constraints. Consequently emerging economies have been able to recover more quickly from the global recession in 2009, and their recovery should continue at a healthy pace in 2010.

What does this mean for investors?

As we have mentioned in previous economic updates, investors are being well-rewarded for maintaining the risk within their investment portfolios. We still believe that whilst there remains risk in some areas where there is earnings and dividend vulnerability, investors are still seeing value in stock prices, particularly where companies have good levels of cash-flow and rising earnings and dividends. 

As previously predicted, stock markets have risen well during the recession and investors who do not currently need cash should look at the longer term potential and take advantage of the recently depressed prices, as we are likely to see higher equity values from these levels. 

At the heart of any well structured portfolio lies diversification of investments and this is likely to be beneficial as the overall impact of market changes occur. Investors are reminded that investments are medium to longer term by nature and indeed investment of time as well as capital is a requirement for any sensible investor. Due to the different levels of risk involved in investing money for an income or capital growth, it is prudent to have a spread of investments over a variety of investment sectors and asset classes to minimise your overall exposure to investment risk and protect against adverse developments in any one particular area. 

Cash Deposits - Returns on deposits in cash have been reduced significantly in the last 18 months as banks, building societies and deposit takers have sought to repair their balance sheets. By lending at a much higher margin than the rate that these institutions pay savers, they can replenish their profits more quickly. Whilst money in cash is relatively safe, savers run the risk, particularly at this time, of eroding the buying power of deposits from the effects of inflation over the medium to long term. In the short term we do not see this position changing.

Fixed Interest Securities - Investments into Corporate Bond funds (loans to companies) have seen unprecedented returns over recent months as the credit markets seek to repair and heal. The initial over-reaction to borrowers defaulting by the markets, created an (huge) opportunity for investors, for which they have been well rewarded since March 2009 by way of increased income and capital growth. Gilts (loans to the UK Government) on the other hand have not seen such significant rises in capital value or income as they tend to be much more cautious. Returns of this magnitude are unlikely to be repeated in the short term. However, we see fixed interest securities as an integral part of any well diversified investment portfolio.

Commercial Property - Whilst commercial property was one of the first asset classes to react to the global economic downturn post summer 2008, it is also one of the last asset classes to respond to the upturn. However, recent returns from the major commercial property fund managers have shown some positive returns to growth. The reason for this is that signs are much more positive across this sector generally and capital reductions in fund values over the past 2 years have been made more due to sentiment and a hypothetical view of commercial property values, rather than evidence based upon actual transactions. We maintain a cautious approach to commercial property investment at present.

Equities - Whilst the award for the best performing asset class of 2009 goes to fixed interest securities, historically equities are likely to remain the best performing asset class over the longer term and we see no reason to think this should not be the case currently. Our commentary above referring to economic growth directly reflects equity values and dividends globally. With its potential comes higher risk and therefore equity investment offers the opportunity for higher returns and consequently remains an integral part of our recommendations within investment portfolios, subject to an investor’s overall appetite for risk.

Sign Up to Our News Alert Service

Complete the form below to receive the latest News updates from Loughtons.