Asset Allocator's Soapbox: Investec's Saunders and King

Philip Saunders and Max King, multi-asset portfolio managers at Investec, give five reasons to be positive.

At the start of the year, we agreed with the consensus view that this would be a good year for investment markets, but disagreed on timing. Others expected a good first half but difficult conditions thereafter, while we expected the reverse. It has been easy to be lulled into complacency as the market advanced only to slip back into despair in each of the two setbacks, but it is important to keep a sense of perspective. In our view:

1. Global equities are, by historic standards, showing exceptionally good value on a prospective 2010 p/e of scarcely 13 and a 2011 p/e below 11. Quarterly earnings have beaten expectations, analysts have continuously upgraded forecasts and are likely to go on doing so. Corporate earnings are expected to increase by over 37% this year and by 20% in 2011.

Despite huge fiscal deficits and a steady economic recovery, government bond yields have fallen in most countries. Credit spreads for corporate issues have widened recently but without evidence of renewed stress, In our view, this only establishes reasonable value again. Therefore the downside to equity markets appears very limited in valuation terms and the upside could be considerable, but macroeconomic factors are likely to dominate for now.

2. The gold price has climbed steadily but other commodities have remained in a trading range that is benign for both producers and inflation. The dollar, whose weakness was unnerving investors a year ago, is recovering strongly against the euro.

3. The global economy is growing at a steady, if modest pace while the impetus to curb fiscal deficits is gaining momentum across Europe and the UK.

4. Neo-Keynesians believe cutting fiscal deficits risks plunging the global economy into a ‘double dip’ recession. However, OECD experience, supported by broader theory, suggests the opposite, provided that it is accompanied, as in the UK, by loose monetary policy and a competitive exchange rate. The new Office for Budgetary Responsibility reduced the UK’s 2011 growth forecast to 2.6% (and then to 2.3% in the Budget), while HSBC expects 1.9% but bear in mind that the forecasts of the previous government always looked unrealistic.

5. In Europe, the benefit of a weaker euro is expected to outweigh the negative of fiscal restraint by a factor of two or three, but dollar strength could act as a brake on the US recovery. The problem with Europe is not the overall economic outlook but how it is divided. One economist estimates that an exchange rate of €1 = 31c is required to bring the Greek economy into balance but €1=$1.80 would suffice for Germany. We don’t believe euro depreciation will solve the problem in southern Europe and nor will deflation. We think, before long, these countries will be forced to leave the euro as the only way to escape a downward spiral of deficits, debt and depression.

The longer it takes, the more turbulent will be the break-up and the more countries will be sucked down. The departure of any country from the euro would mean its euro debts would be converted into the new local currency at the pre-devaluation rate. This would impose massive losses on holders of those debts, many of which are European banks with thin capital ratios. A new banking crisis would be possible if European governments did not act to shore up the banks. Much of this is already reflected in the price of the sovereign debt of vulnerable countries and in the share prices of exposed European banks but it could result in short-term market chaos.

Thereafter, the collapse of unstable and unsustainable currency fixes is always a positive event, leading to rapid economic recovery and booming asset prices. It is arguable that investors should hold off from risk assets until then, but there is no reason why the problems in the euro zone should derail a steady global recovery or push global markets to even cheaper valuations.

For now, markets face a significant headwind but the conversion of the market rally of 2009 into an enduring bull market and the creation of a basis for enduring growth will require governments in developed economies to embrace drastic fiscal action, currency reform and monetary stimulus. In our view, the lights are not yet flashing green but we are not far off.