A strong quarter behind us:- gains to continue but at a slower pace

By Noel O'Halloran , Wednesday, 7th April 2010 | 0 comments

The first quarter was a positive one for most financial markets. As expected, it was also a volatile quarter, with positive and negative forces strongly to the fore in both directions, with the “good” finally winning out for the quarter. It is also worth noting that it’s now just over 12 months since the bear market lows of March 2009. The MSCI World Equity index rose by 9.6% in the quarter, and stood 67.7% above its March 2009 low, while the Merrill Lynch over 5 year sovereign bond index rose by 3.1% and 9.6% over the same periods.

Looking ahead
I believe that the easy money has been made during the market bounce of the last 12 months, and that from here markets will most likely grind upwards, making further more modest gains. The good news is that the economic recovery IS on a sustainable recovery path, with "double-dip" risks relatively minimal. Economic releases over the first quarter have been consistent with recovery and corporate profits in particular continue to be ahead of expectations. Equity markets themselves are a good leading indicator of activity, and to me are suggesting that data in coming months will continue to be positive. Soon we will begin to get the announcements of US corporate profits for the first quarter and I expect them to be strong. So in the short term, I expect equity market momentum to remain positive.

As we go through the next number of months, I do however believe that we will enter a more “tricky” period for both equity and bond markets potentially. In such a period markets are likely to be vulnerable to setback. To date we have been in a “sweet spot” where extremely low interest rates, attractive valuations and a recovery in economic growth and profits have been positive for risk assets.

Perhaps paradoxically, the more assured the recovery becomes over the coming months, the higher the probability that central banks will start to tighten interest rates again. So good or strong economic news may not translate to good news for the markets. This we expect to occur sometime from September onwards. The bad news is that historically such a phase tends to burst the “sweet spot” for a period and markets tend to struggle. The good news however, is that whilst we remain very comfortable that the economic recovery will continue, we continue to expect a relatively subdued recovery as we move to the “new normal” world that is less exuberant than the world that entered the recession. A subdued, though solid, economic recovery means that interest rates will not be raised aggressively.

In summary, the next 6 months will be more tricky for equities, but on a 12 to 18 month time horizon I foresee further double digit potential. For government bonds I am much more concerned and believe that there is a significant probability of higher yields (lower prices) as a result of the combination of rising interest rates, economic recovery and record bond issuance to fund huge government deficits.

Fundamentals
Apart from the economic environment already discussed, equity market valuations remain undemanding and the recent moves have been in line with profit growth, which I expect to continue. Company managements have been aggressively managing costs and hence margins and this, combined with a gradual pick up in sales growth, will drive further profit gains that will continue to outstrip economic growth. While there is much media coverage of the bad condition of government and consumer debt and balance sheets, for corporates the opposite is true. Companies in general have low debt levels and strong cash levels. This is positive for future usage be it capital expenditure, increased dividends or acquisitions.

Events to Monitor
There will be both upward and downward pressures on markets in the months ahead. Events that are likely to shape this are:

- A focus on sovereign risk, and the possibility of the current difficulties being experienced by Greece broadening out to other countries such as the UK or even the US
- The possibility of a hung parliament in the UK affecting Sterling and the UK bond market
- The strength of economic data and the pace at which the market starts to build in expected interest rate rises, particularly in the US
- Emerging market concerns, in particular the Chinese economy
- The potential for increased corporate M&A activity

In Summary
It’s been a story of “so far so good” in terms of the roadmap we have expected for the markets and economies, with a struggle more likely over the next quarter or two. For your portfolios, we are still cognisant of the risks that remain out there and believe that when picking stocks, quality and income remain paramount. For multi-asset portfolios we continue to encourage diversification, and this is likely to be particularly important given the “two-way” markets we expect over the next few months. In the absence of a robust economic recovery, companies (and governments) with large debt will struggle and there will be a clear differentiation between the winners and losers. The low quality, highly indebted companies that were the winners during the bounce, will struggle from here.

Regionally we continue to favour emerging markets which have both good economic and profit growth expectations and attractive valuations. European markets have recently been out of favour due to concerns about Greece and this may provide an opportunity to invest there.

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