Investment Outlook 2010 Q1


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Investment Outlook 2010 Q1

  1. 1. QUARTERLY INVESTMENT OUTLOOK “The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” William A.Ward
  2. 2. 2009 a year of paradox 2009 was a year of paradox. While it was a year when the UK economy was mired in recession and government finances spiralled out of control, it was nevertheless a great year for investing in financial markets. This paradox proves that investing successfully is about assessing what is currently discounted in the valuation of an asset, and then judging whether that is fair. If assets are cheap enough then they can perform well even through a recession. A year ago we concluded we were “excitedly optimistic about the prospective performance of some investments, even while holding a realistically downbeat view for the economic outlook” (Hawksmoor Investment Outlook for 2009 December 2008). Looking ahead to 2010 we continue to hold a downbeat economic outlook, and given the sharp rally in many asset prices we feel a much more discerning approach will be required to make money than proved to be the case in 2009. A year ago the valuations of many “risk assets” (such as shares, commercial property and corporate bonds) were extremely depressed and looked cheap even should there be a prolonged economic slump. A year later, after a substantial rally, this is no longer the case and there is a risk that the strength of the economic recovery discounted in some areas of financial markets will turn out to be too optimistic. There are very stiff headwinds to growth that are likely to become increasingly apparent as we go through 2010. These headwinds have been created by the lingering wounds to the global financial system from the Credit Crisis and the need to reverse some of the emergency fiscal and monetary measures that were adopted to prevent a collapse of the banking sector and a deflationary slump. Nevertheless, as the American writer William A.Ward observed,“the pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” By acknowledging the difficulties of the economic climate which we face we have been “adjusting our sails”, endeavouring to find the best areas of financial markets in a difficult environment. Fortunately, even though we are cautious about the economic outlook, we continue to find attractive investment opportunities, even though it is important to be realistic about the prospect for much lower returns than we saw last year. An end to Quantitative Easing? When assessing the current valuation of investments it is important to remember that the spectacular rises in share and corporate bond prices since March 2009 occurred from abnormally depressed levels. Valuations became extreme because for a time it was possible that a deflationary slump would develop leading to a raft of bankruptcies and defaults. Many of the companies that have since seen their share prices lead the market rally came close to financial disaster early in the year, and it was only the re-opening of credit markets in the Spring that enabled them to refinance their enfeebled balance sheets and survive.This shows how vital the adoption of Quantitative Easing (QE) by western central banks was to lay the basis for the recovery in asset markets. Coming on the back of slashing interest rates close to zero, the authorities adopted QE to inject vast amounts of liquidity into the financial system by purchasing bonds with newly-created money. The combination of receiving this cash for the bonds sold to central banks and the pitiful interest rates available for holding cash on deposit meant money suddenly flooded into financial assets, fuelling a recovery in prices and enabling companies to issue new bonds and shares. Understanding this background is vital in looking forward to assess what is likely to happen in 2010. This is because in formulating an investment strategy it is necessary to judge what will happen to financial markets when emergency liquidity measures are withdrawn.The period we have seen of QE is without precedent, and in our opinion the popular strategy of extrapolating the performance of asset prices following past economic recoveries is not appropriate for current conditions. We believe we are at a pivotal point during which the world economy is transferring from growth led by debt-driven consumerism in western developed nations to growth led by continuing strength in emerging economies. However, while the strength of emerging economies will provide some support for western nations it will only temper what is likely to be a period of greater austerity for developed economies during which debt will need to be paid down and inflationary risks will be building. If this sounds too gloomy and we are pleasantly surprised, then we would prefer that to the alternative! However, a cautious approach is warranted. This involves having a diversified portfolio of investments that are not all positively correlated with one another, and responding flexibly to changes in the environment when they become apparent.
  3. 3. Our investment strategy for 2010 The starting point to any investment strategy should be to assess the likely prospective returns of an asset compared to the risk free rate of return. In this respect the returns offered by the lowest risk investments such as cash and short term government bonds remain exceptionally low, and unattractive for all but those who believe most asset prices are set to fall. While we believe that financial markets will be far less buoyant in 2010 than 2009, and that prices in some areas look vulnerable to bad news, we continue to hold very low levels of cash, reflecting our view that financial markets hold attractive opportunities. Our attitude to corporate bonds illustrates this. A year ago we believed that corporate bonds would deliver strong total returns, given the scope for their prices to recover. Even though the scope for capital gains is now modest, we still feel that that talented bond managers who actively manage their portfolios and hedge interest rate risk should be able to produce returns that beat the risk free rate of return by a considerable margin. By contrast, we remain negative on the prospects for most government bonds, notably those in economies set to struggle with huge public deficits. For example, QE has kept UK Gilt yields artificially low and the risk of a sharp rise in yields is increasing, given the weak state of public finances and the future threats of inflationary consequences to the authorities’ measures to counter the recession. Although we remain optimistic about the economic outlook for emerging markets we believe that some of the most attractive investment opportunities to benefit from growth in the emerging world are the shares of major companies quoted in developed markets including the UK. Over 70% of UK corporate earnings are now derived from overseas, and the valuation of many large dependable companies with global franchises quoted in developed markets around the world look attractive. We particularly favour those paying significant and sustainable dividends. Reflecting this among the core holdings in our portfolios are well managed global equity income funds delivering income at a level well in excess of that of 10 year government bonds and with scope to see increases in distributions. We have also made investments in high quality UK commercial property vehicles following the sharp sell-off, in the expectation that a decent level of income combined with some albeit modest, scope for a recovery in capital values will prove to be an attractive proposition relative to cash. We have recently been increasing our exposure to one of the laggards in 2009 - Japanese equities. With over half of Japanese exports now destined for other parts of Asia, the Japanese equity market is fast becoming the forgotten poor relation of the Asian growth story. Moreover, around 20% of Japanese listed companies trade below book value, have net cash on their balance sheets and are profitable - a level of extreme value seen in only a handful of cases in most other equity markets. Investment in Japan also provides diversification benefits: Japan is the only major developed market yet to benefit from surging liquidity in this cycle and we believe it is unique as a market that would benefit rather than suffer if inflation were to become a global concern. Conclusion Investment is a long term game played out in a multitude of short intervals. Writing a quarterly investment outlook is a reminder of this and it creates a temptation to change stance too frequently or to underestimate the importance of major long term driving forces in financial markets. We therefore need to balance an approach that backs long term investment themes with making tactical changes to adapt to a fast-changing environment. The past eighteen months has been a highly unusual period in which asset prices have been on a roller-coaster of plunging and soaring movements reacting to events of an historic magnitude. Just as investors over-reacted to bad news pushing prices too low, we feel that they have over-reacted during the bounce-back, pushing some prices too high. In doing this, high quality investments have often been ignored in favour of those most sensitive to a strong economic recovery.The good news is that this has created opportunities to rotate our portfolios, buying high quality investments at a discount or, as one of our favoured fund managers John Wood of JO Hambro put it, to find “Waitrose-quality companies that are valued at Aldi prices.” 2010 is highly unlikely to be as rewarding as 2009, but by a careful approach seeking quality, dependable income streams and modestly valued investments exposed to high growth areas we hope to provide another good year of performance for our clients. Richard Scott 21st December 2009 HA076
  4. 4. Waterfront House Wherry Quay Ipswich Suffolk IP4 1AS t: 01473 261300 3 Barnfield Crescent Exeter Devon EX1 1QT t: 01392 410180 e: This document is provided for information purposes only and should not be interpreted as investment advice. Whilst the information contained in this document has been prepared in good faith, no representation or warranty, express or implied, is given by Hawksmoor Investment Management Limited or any of its Directors, partners, officers, affiliates or employees. Past performance is not a guide to future performance. HA047 Hawksmoor Investment Management Limited is authorised & regulated by the Financial Services Authority Incorporated in England & Wales • Company Number 6307442 HA047