Investment Outlook, Spring 2007

The steady and controlled capital appreciation that characterised global markets since mid- 2006 came to an unexpected halt in late February, when the MSCI World Index had come within an ace of its all-time high.

Confidence stalled
An unexpected sell-off in the Shanghai stock market triggered significantly greater falls in other speculative asset classes, such as emerging market equities and commodities. Volatility spiked, as leveraged investors scrambled to reduce their risk exposure, with widespread substantial losses. The catalyst for the fall was the rumour that China might introduce a capital gains tax to clamp down on speculation. Foreign investors read this as a prediction of an economic slowdown, with the likelihood that emerging market risk had suddenly increased. In addition to these factors, the publicity given to Alan Greenspan’s comment about the significant risk of recession in the US, and the collapse of the sub-prime mortgage market rattled investors.

Market imbalance, not deterioration

In our view, the recent turbulence reflects market imbalance rather than deteriorating fundamentals. It is clear that the US economy is slowing as a result of the weakness in the housing market and in manufacturing. There are also concerns that the problems of the sub-prime lenders might spread to the broader financial market. However, the US economy seems unlikely to plunge into recession given the recovery in consumer spending power. Several indicators that historically have been predictive of recession may be flashing red, but a proactive Federal Reserve under Bernanke’s governance would mitigate any perceived downturn, probably by cutting rates.

Is expansion slowing?

There is little sign that economic growth in the rest of the world is slowing – forecasts have been steadily revised up in the Eurozone, and we still expect growth in China to approach double digits this year and next. Only Japan, where wage growth remains negligible, seems to be lagging. Furthermore, global expansion is taking place against a background of subdued inflation that suggests that interest rates will remain on hold until the summer. In short, we believe that global economies are still at their mid-cycle phase, and that corporate profits are less vulnerable to a cyclical downturn, although their growth could slow to pedestrian levels, especially in the US.

Predicting rates of growth

On valuation grounds, there seems to be limited downside risk given the recent fall in bond yields, together with the increasing possibility of rate cuts later this year. While the long-term growth of real US corporate profits has been well above trend since 2005, a more subdued growth rate need not lead to weaker performance while the gap between earnings yield and cost of capital remains close to record highs. However, this does suggest that markets will be increasingly sustained by mergers and acquisitions activity, with increasing sensitivity to the health of the US housing market. Taking in all of these factors, it’s clear that stock picking will become ever - more important this year.

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