Market commentary October 09

Market Commentary

for the period
6th April 2009 to 5th October 2009

UK equities

FTSE All Share Index +29.6%

A combination of very low interest rates, the Bank of England’s £175 billion intervention (purchasing gilts and corporate bonds) in the bond markets and weak sterling has contributed significantly to strong investment returns over the last six months as the financial markets breathed a collective sigh of relief that the global economy wasn’t entering a depression. The best performing sectors for the period have been the Industrial Metals, Banks, Life Assurance and Automobiles which were the areas of the economy most affected by the financial crisis as many of the highly indebted companies were being priced by the market for potential bankruptcy or outright nationalisation in the case of the banks.

The latest official Gross Domestic Product (GDP) numbers for the second quarter of the year show that the UK economy contracted by 5.5% over the previous 12 months, a deep recession by any standard, although the consensus forecast from the Economist Intelligence Unit is for a return to positive growth of 1.4% in 2010. Business surveys have pointed to a trough in economic output as firms look to replenish their inventory levels however, credit conditions remain tight as banks continue to repair their balance sheets and high levels of public and private debt will continue to weigh on spending. Overall, it is likely that the UK economy will emerge slowly from the recession although the exact timing and strength of that recovery remains highly uncertain as strong headwinds remain.

The Consumer Price Index (CPI) which measures the rate of inflation fell to 1.1% in September (the Government target is 2%) representing a general weakness in prices. A continuation in the rise of unemployment which is currently at 7.9% of the working population and spare capacity in the economy will place downward pressure on wages. The Bank of England base rate is unlikely to rise in the near future as the damaging prospect of a period of protracted deflation still concerns policymakers.

The fair value of the UK’s main stock markets is notoriously difficult to calculate at key economic inflection points as company valuations rise quickly in anticipation of a recovery in corporate profits. Analysts will be looking for good profit announcements from companies in support of current prices with any disappointment leading to the market pulling back from current levels. However, record high levels of cash held in money market funds over the last couple of years are being tempted back into real assets given the poor returns on deposit based investments currently on offer.

International Equities FTSE World (excl.UK) Index +23.2%

In the United States, the S&P 500 returned +25.9% (+23.2% in sterling terms) during the period. The consensus forecast for economic growth in 2010 is 2.5% rising from a trough of -3.8% over the last twelve months, whilst unemployment has continued to rise to 9.8%. The role of the U.S. dollar as a reserve currency is at the heart of the debate about how the global economy should be rebalanced following the financial crisis. Put simply, the U.S. consumer needs to save more and the Chinese people need to spend more, which is a sharp reversal of modern history. However, the state of U.S. finances (the total outstanding ‘national debt’ is currently $12.8 trillion) requires an orderly devaluation of the U.S. dollar over time as China in particular will become increasingly wary about lending money to an already heavily indebted country.

In Europe, the FTSE Eurotop 100 index rose by +29.3% during the period. The GDP figures for France and Germany indicated they were emerging from the recession at a faster pace than the U.K. although their unemployment numbers are still high at 9.9% and 8.2% respectively. Spain currently has a distressing unemployment rate of 18.9% and is one of the few countries in the European Economic Area (EEA) projected not to emerge from recession during 2010. The economies of Ireland and Latvia in particular remain in a parlous state and both countries are likely to suffer painful economic contraction throughout 2010.

Japan experienced a change in political leadership for the first time in over fifty years with the election of the Democratic Party of Japan (DPJ) representing an opportunity for domestic economic reform. Japanese equities are currently standing at low valuation levels not seen for over forty years (using price/earnings and price to book ratios) but high levels of government debt and an ageing population continue to suppress a shift to higher levels of economic growth.

In the Asia Pacific region, the benchmark MSCI Far East (excl. Japan) Index rose by +35.2% in local currency terms. China remains the engine of growth in this region and is forecast to post stunning economic growth for 2009 of 8.2%. The Chinese Government has injected a large financial stimulus to their economy over the last year with investment in infrastructure projects creating a huge demand for commodities which are mainly supplied by the emerging markets. However, there is growing evidence of over capacity with analysts monitoring signs for any weakening of the economic growth rate falling below 8% per annum. The Chinese stock market fell by over 20% in August following a severe drop in the July lending numbers (down 77% on the previous month) delivering a sharp risk warning to complacent investors. Hong Kong, Taiwan and South Korea have also produced some stunning economic growth numbers in recent quarters whilst Australia has weathered the financial crisis in a relatively robust state following the recovery in commodity prices. Indeed, Australia is one of the first of the leading industrialised nations to tighten monetary policy by raising interest rates.

The MSCI Emerging Market Index produced a return of +35.5% as the appetite for risk returned to equity markets. According to the IMF World Economic Outlook and MSCI data, The Emerging Markets contain 80% of the world’s population, produce 50% of global GDP and yet their markets represent only 12% of total world equity market capitalisation (i.e. stock market value). The impact of globalisation including travel, migration, mobile phones, urbanisation, global trade, capital flows and the internet all continue to drive the synchronisation of emerging markets with the developed world.

Fixed Interest FTSE British Govt All Stocks Index +4.5%

The Bank of England’s programme to purchase £125 billion of assets consisting of Government Gilts and high quality corporate bonds in a process known as ‘Quantitative Easing’ (QE) was extended by a further £50 billion in the period under review. The future level of interest rates, signalled by government bond yields, has remained below 1% over a two year time frame with low expectations of rate rises in the near future.

The most important question perplexing bond investors continues to be whether the UK economy is facing a protracted period of deflation, which would suit investors holding conventional gilts or rising inflation, which would suit holders of index linked gilts. In the Bank of England’s September Inflation Report, the Monetary Policy Committee stated that inflation will be extremely volatile over the coming months as the reversal of the V.A.T. increase comes into affect alongside other tax changes. The evidence remains very mixed for both sides of the argument at this juncture.

The performance of corporate bonds has been very strong since March with the iBoxx Corporate Bond Index rising by +25.5% as fears over a high percentage of companies defaulting on their obligations have receded for now.

Commercial Property FTSE All UK Property Index -4.9%

In September 2009, Britain’s commercial property market delivered the largest monthly capital growth since June 2006 at 1.1% according to the IPD UK Monthly Index. While the monthly capital growth figure is the largest in more than three years, it was contained by falling rents. The 12 month change in capital values has fallen to -25.3% falling from a record high of -31.5% for the year to May 2009.

Alternative Investments FTSE APCIMS Hedge (Investment Trust) +11%

Absolute return style investments which produce flattering returns in a declining market have lagged the broader stock market indices in this recent market cycle which is to be expected. They remain an important portfolio tool given the uncertain economic environment going forward.

IFPC Ltd is authorised and regulated by the Financial Services Authority

Index performance: for period 6th April 2009 to 5th October 2009, total return with income reinvested
Source of statistics (unless otherwise stated): Lipper Hindsight, Alpha Terminal

Disclaimer: this document represents investment commentary of a general nature and should not be used as a basis for making personal investment recommendations. It does not take into account personal investment objectives and you should contact an adviser at IFPC Ltd if you require further financial advice.

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