Positive factors aid market recovery

By Noel O'Halloran, Thursday, 1st October 2009 | 0 comments
Noel O'Halloran, Chief Investment Officer provides an investment outlook
The rolling 6 month returns since March are at historic record levels for European equities, gaining over 50%. The world equity index return of almost 15% (in euros) in Q2 was added to by a further rise of 12.8% (in euros) in Q3. Bonds also rose in the quarter, by 4.1% (as measured by the Merrill Lynch over 5-year European bond index). Notably, equities rose in all three months during the quarter. Corporate bond markets also performed very strongly reducing the price of funding corporate balance sheets. So, as is normal coming out of recessions, risk assets outperformed monetary assets and cyclical sectors outperformed more defensive sectors. We have generally embraced more risk for all portfolios, and as forecast in my Q3 outlook article, we did reduce cash in favour of equities during the quarter.
As I reflect on the macro situation during the quarter there was certainly evidence that a gradual recovery was occurring, which is what we expected. This was aided by events such as inventory restocking or car scrappage schemes, and GDP for most countries was positive for the quarter. However, there was no real evidence of increased bank lending or strong consumer spending.
The Surprising shape?
Given the relatively muted recovery to date, the surprise for the quarter was that the markets did NOT debate the “shape” of the recovery. Instead, asset markets raced confidently and relentlessly to rapidly price in a good old fashioned “V” shaped recovery. An absence of bad news and some good news drove this, in combination with the following factors:
  • Central banks continue to be very friendly to the markets. They have maintained very low interest rates and paint an outlook of muted recovery with no inflation concerns on the horizon. Low interest rates and strong money supply is perfect for both equity and bond markets as it powers a liquidity fuelled market rally.
  • Economic growth and profits are improving. Second quarter profits were more positive than expected, fuelling hopes of a strong earnings recovery.
  • Investor positioning: investors and corporate executives have been surprised by the strength of the market recovery to date. They equally were positioned too defensively. Many investors found themselves underweight in a rising market and were forced to put money into markets, hence pushing them higher.
 Turning to the outlook over the coming months to year end and into early 2010, there would appear to be little to upset many of these positive momentum factors, albeit that the pace may be slower. Growth and earnings momentum should continue and liquidity remains abundant finding its way into asset markets and particularly riskier assets such as equities. Thus, I expect that equities will end the year higher than now. In terms of valuations, equities are not cheap anymore (having rallied by over 50% from their lows), and are now more in line with long term averages. The chart below demonstrates European equities trading currently close to their long term average multiple of 15.
It is noteworthy that despite the very strong performance of stock markets in recent months, comments from company management teams continue to be relatively conservative, and are not telling us that they are seeing any material pickup in business yet.
Medium term: ‘shape of recovery’ questions to return.
For a medium term minded investor, however, I believe the question of the “shape” of the recovery will come back with vengeance and will severely test the “animal spirits” that are currently driving markets. We will be very alert to this challenge when weighing up the risk and reward opportunities. In particular, we are considering the following key issues:
  • The expected growth rate of corporate profits in 2010 and beyond.
  • The consequences of massive deleveraging of consumer debt and high unemployment levels.
  • The poor state of government finances around the world
  • The re-capitalisation needs of the global banking sector
  • The risk that central banks are too dove-ish and are thus now in the process of inflating another asset bubble through monetary recklessness
  • The risk of inflation being surprisingly high
  • The timing of interest rate increases?
 In summary, on a 12-18 month view I remain bullish on the outlook for equities in particular. I do want to equally highlight that there is a risk that the animal spirits of markets will be carried away on the upside into another bubble, unless checked by central banks or perhaps fears of a double dip again. We will not chase risk assets prices upwards unless we believe the fundamentals and valuations justify it.
In the meantime we will keep you updated with any significant changes in our views.

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