May Fire Drill!

By Noel O'Halloran, Thursday, 3rd June 2010 | 0 comments

In my most recent blog in April, I highlighted that the easy money had been made and that we expected a “tricky” volatile period for equities over the next 6 months. The month of May just ended was a negative and at times “scary” month for risk assets such as equities and commodities - a month that most dramatically challenged the positive tone of the previous 12 months during which we had seen a huge equity market rally, and one where the spontaneous market reaction was to run for the hills and seek safety in less risky assets such as gold and safe government bonds such as those of Germany.

The market falls were caused by:
  • the European sovereign debt crisis
  • geopolitical tensions, as seen in Korea and  Thailand.
  • above all, the risks of a double dip recession occurring in the western developed economies
Returns for the month are shown in the box below:
World Equities (MSCI, €) -1.9
European govt bonds (ML 5yr+, €) +1.9
European Equities (Eurotop 300, €) -5.8
Euro vs US Dollar -7.4

Equity markets now look cheap and bond markets expensive. Just two weeks ago, the German 10 year bond yield hit a 200 year low!! I believe we will make double digit returns on a 12 to 18 month horizon, but in the next 6 months the environment will remain volatile and tricky.

We don’t believe that this is the beginning of the third great bear market in a decade. We do see a reversal of the trend of recent weeks. In a headline driven market environment, headlines change and I expect we will soon move on from the “Euro crisis” headlines. This will be a sign that the baseline economic and market recovery scenario remains on track and this in itself will comfort risk assets and lead to a reversal of the recent risk aversion in markets. Our baseline scenario remains one of expecting a subdued and bumpy economic and market recovery from here.
However, while a recovery (albeit a bumpy one) is our baseline scenario, we continue to highlight that:
  • We are just at the beginning of an economic recovery, not the end, which is very different to circumstances in 2008.
  • We do not expect a “V” shaped recovery and believe the coming “new normal” will be a more subdued and volatile, though positive, world for the next 5 years or more
  • We can expect periods of over-exuberance and negative over-reactions in markets
May for me was a timely “fire drill” for all as to how things can go wrong very quickly again. Indeed, the events during the month highlighted the urgency of strong political and central bank leadership and co-ordination. By its very nature, the relatively subdued and fragile economic recovery is particularly dependent on confidence being maintained, and particularly consumer confidence. Strong leadership is a key driver of confidence.
In managing your portfolios, we believe the environment we have described above favours secular growth areas such as emerging markets, strong quality over poor quality earnings, and we continue to emphasise dividend income as an important part of overall return. We also strongly advocate to clients the need for meaningful diversification of portfolios.
We will continue to communicate with you as we go through the summer months.

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