Notable positive factors are easy to overlook if we focus solely on the obvious difficulties in the market, writes Daniel Lockyer and Richard Scott of Hawksmoor
A successful investment strategy requires an acute awareness of the huge challenges faced by the world economy, and the readiness to react quickly to changes in important trends. Nevertheless, for all the challenges facing investors, ranging from the fragility of the global economic recovery through to the risks of sovereign debt defaults, there are also some notable positive factors which are easy to overlook by focusing solely on the obvious difficulties we face.
In addition to low interest rates and the continuing rapid development of emerging economies, one of the most positive forces supporting asset prices is the healthy state of major parts of the corporate sector. Many companies are achieving strong growth in profits and are putting plans in place to prosper even in a lacklustre economic environment. US corporate cash flow has now surpassed the record reached in 2008 at the onset of the credit crisis and the outlook for profits looks strong in most areas of the world for the rest of the year.
Looking ahead
In developed economies there is less room for optimism looking ahead to 2011, when emergency measures employed to prevent a depression are removed and fiscal tightening is required to heal public finances. These two developments will act as brakes on economies without obvious positive forces to replace them to drive growth. It was instructive to hear firsthand from the Governor of the Bank of England, Mervyn King, in a speech delivered at Exeter University on 19 January, when he said “there is a long period of healing ahead” for the global economy and problems in the financial system cast “a shadow over our economic future”.
King went on to speak of the need for a politically inspired solution to the imbalance between excess saving in the East and deficits in developed economies, which fuelled the credit crisis. With tensions building between the authorities in the US and China over the value of the renminbi, this problem remains a serious source of concern. In the aftermath of the UK general election, while encouraging to see the large deficit being addressed, there is still uncertainty about the longevity of the stability of the coalition.
An unusual state of affairs
There is plenty to worry about, but our interpretation of the key factors at work in the global economy affecting financial markets remains the same and we do not feel anything has changed to warrant a move to an outright defensive position. As a result we have made comparatively minor changes to our strategy over the past three months.
Our policy has been to act when we have judged prices of investments we hold had risen too far, causing us to either take profits or sell out completely. For example, having ridden strong rises in the value of funds invested in some of the most oversold areas of bond markets (such as convertibles and secure loans), we have changed the focus of some of our fixed interest exposure to invest in more diversified and conservatively managed strategic bond funds. Money flowing into bonds has created pockets of over-valuation: for example, yields on some blue chip companies’ bonds such as Glaxo and Vodafone are now substantially lower than the dividend yields on the same companies’ shares. This is an unusual state of affairs given that UK companies’ bonds have historically tended to yield 2.5% on average more than their shares.
This observation is relevant to one of the areas we continue to believe holds the most attraction in global markets, namely high quality shares paying decent dividends. We hold a number of positions in well managed global equity income funds and, even though these have performed strongly in recent months, we remain very positive about their prospective performance.
Strong Japan
We are also encouraged by the strong performance of our Japanese equity positions since we added to exposure. While we believe deep-seated problems in Japan’s economy need to be watched, excellent opportunities remain for the managers of our Japanese equity funds to make further attractive returns. We also retain a guardedly optimistic outlook for some equity growth and property funds albeit we are concerned about unrealistically bullish expectations reflected in accelerating inflows into many emerging market and UK commercial property funds. One of the problems created by low interest rates is the danger of inflating asset bubbles, a risk the Bank of England has commented on in the reports of its deliberations in determining the appropriate monetary policy.
In the light of this we have taken some profits and introduced more defensive holdings into portfolios, including a holding in an absolute return fund that should produce good returns should there be a setback in markets.
The rally in markets is causing an increasing polarisation of views among investors; with some commentators warning of another crash while others arguing the rally since March 2009 is still in its infancy. We predict the bulls and bears will both be thwarted by global financial markets trading in a volatile fashion without making major headway in either direction. After the huge rally triggered by avoiding an economic depression, the rest of 2010 is likely to be comparatively dull for returns, if not for events, which will cause frequent about turns in investor sentiment without being decisive enough to enable markets to break out up or down.
Faced with this level of uncertainty, it is understandable that the most cautious of investors will be reluctant to embrace the risk involved with investing in financial markets. However, we believe that a broadly diversified portfolio with a central theme of focusing on good quality assets paying superior yields should deliver returns in 2010 that are not just decent in an absolute sense but that also compare favourably with those of markets overall. In the event this strategy proves too cautious, it will have still resulted in achieving good returns even if they fail to keep pace with markets, while if our view is too optimistic then the downside from most of our investments should prove bearable, especially in the sense that we are investing in high class assets that would recover from short term setbacks.
Daniel Lockyer and Richard Scott are co-managers of the Hawksmoor Vanbrugh fund
