Global market weakness - investment update
Thursday 11th August 2011
Here, Andrew Cole, Investment Director, Global Multi Asset Group, Baring Asset Management, considers what next for the world economy...
Since 22 July, the MSCI World Index has declined by 8.4% while the MSCI Emerging Markets Index is off 6.6%, in US dollar terms, bringing both firmly into negative territory for the year to date. This has been matched by a steep fall in government bond yields, with the benchmark US 10-year bond at 2.62% and 10-year Gilts touching new lows at 2.61%.
The reasons for the recent weakness:
There is no single catalyst, but investors are concerned about both the debt crisis in the euro zone and the pace of economic growth around the world following a spate of weak economic data. Starting in the euro zone, bond market investors shifted their attention from Greece, after a deal was agreed which might ring-fence a default, to Italy and Spain. Even French bonds have been affected, in a worrying escalation of the funding crisis from peripheral to core Europe. The solution which worked for Greece could not work for these much larger markets, and so we enter a situation where the euro zone project itself is under threat.
The situation has been exacerbated by the effect of regulatory changes in the US, where banks are now able to pay interest on deposit accounts for the first time, and the authorities have agreed to offer unlimited deposit insurance. Taken together, this has undermined the investment case for US money market funds, which have seen major outflows - US $ 60billion last week, and US $ 120billion the week before. As much of 40% of the assets of these funds are estimated to be invested in European bank paper. As assets flow rapidly out of these funds, these banks lose a major source of funding, precisely at the time that it is difficult to access liquidity in their domestic markets. Inevitably, this has fuelled concerns about an escalation of the financial crisis in Europe.
Unsurprisingly, economic data from Europe have been weak in this uncertain environment. More than this however, economic data have generally been weak or disappointing around the world, and there is concern that they are unlikely to improve for as long as governments in the US and Europe are attempting to tackle fiscal difficulties. Revised data released last week showed that the US economy grew at an annualised rate of just 1.3% in the second quarter of the year and 0.4% in the first three months of 2011, in contrast to the more rapid growth which would normally be expected coming out of recession, and this has led to concerns that the "soft patch" of growth could tip back into a "double dip" recession.
Our investment strategy in this environment:
To ignore the seismic policy developments that are dominating markets would be a dereliction of duty, but the dangers of being caught in the latest headline are meaningful. And so we focus on whether our estimates of risk premia available in markets are sufficient to account for all these risks. Broadly, we find them wanting not only in equity but also in bond markets. As such, we are inclined to look more positively on cash today, likening it to a call option on uncertainty.
Within government bonds, our preference is for the Australian government market, given its strong debt dynamics, weak domestic economy, active and independent central bank, and its reliance on continued economic strength in Asia for what growth it can expect to enjoy. We remain cautious on the outlook for euro zone government bonds. Even German government bonds, although they enjoy a safe haven status at the moment, would be challenged either if the union becomes closer and fiscal burdens are shared, or if the crisis dissipates and the premium currently attached to Bunds is lost.
We are, however, inclined to look positively on emerging market local currency debt in this environment. The fundamentals for emerging economies are significantly stronger than their developed counterparts today, and this area of the market has continued to see healthy inflows from investors.
Within equities, we continue to like the US equity market and, for some strategies, multinationals with a significant US tilt. Valuations are attractive, corporate results have been very strong, and it is likely to find technical support as pension funds reduce international exposure in the short term. Although economic data have disappointed, today's non-farm payrolls number was better than expected and may indicate that the soft patch is indeed that.
We have, however, become more cautious on the prospects for developed Europe. The recent corporate results season showed that many companies are struggling to increase profit margins. Against a very uncertain economic environment, volume growth is likely to be challenging too and we see more attractive opportunities elsewhere.
Elsewhere, in the short term, as we have said, the world's emerging markets are likely to face some liquidity pressure. Medium to longer term, however, we continue to believe that the fundamentals of the world's emerging economies are stronger and that economic growth and therefore corporate profits growth are likely to be higher than for their developed counterparts.
Here, we believe that investors could view the recent weakness as an opportunity to participate in the growth and development of these economies at an attractive entry point. We are particularly positive on the prospects for China from here, and for countries such as Indonesia, members of the Association of South-East Asian Nations grouping, where we see additional potential for positive currency appreciation.
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