Strong profits keep equities buoyant

Equity and bond markets posted strong returns despite the credit crunch – but investors should spread risk to maximise returns by diversifying and taking a manager-of-manager approach.

While the increased volatility and concerns over the American subprime mortgage market have been headlines for months, both equity and bond markets have posted strong gains for the year so far – and several major equity indices remain near record highs reached in October.

Still, global stockmarkets fell in the first half of November, and bond yields have dropped further across the board, on concerns that the extent of the credit crisis caused by the American mortgage market is still not properly understood. This is despite the Federal Reserve’s half-point cut in interest rates in September and a further quarter-point easing since then.

The global financial sector has led the markets lower in the wake of the latest Fed cut. However, these losses should be seen in the context of the rest of the market and over the longer term. The MSCI World index returned 3.75% from the start of the year to November 15. The materials and energy sectors have also performed strongly, driven by robust economic growth across the globe, and in Asia in particular. Major indices are trading near their historical highs and the recent increases in volatility and risk aversion have had little impact on the performance of the MSCI Emerging Market Equity index (in dollar terms), which was up 34.24% for the year to November 15.

For active managers with a long-term investment horizon the current turbulence could be seen as a welcome development. It increases the opportunities for finding securities whose valuations have become attractive, even when assuming the worstcase scenario from the credit crisis.

A stable investment strategy, aiming to provide a broadly diversified, core investment offering with a risk-controlled approach to long-term investing can weather such turbulence. A full investment in the global capital markets at all times is advisable, whether rising or falling, as global equity and bond markets are expected to offer attractive returns over the long term. However, these benefits come with an acceptance of short-term volatility, as experienced by today’s markets.

In addition to providing exposure to a variety of equity and bond markets, it is advisable to seek to add incremental value in a risk-controlled way through manager selection and portfolio construction. A manager-of-managers approach, employing several specialist managers within each fund, each with a different investment approach and skills, can also help to generate consistent returns in excess of the benchmark over the long run.

A key feature of the bout of falling markets and rising volatility was that it came against a backdrop of strong economies and corporate profits around the globe. As equity markets have suffered bouts of intense selling, the fundamental situation has remained supportive, and equity markets are trading at price/earnings (P/E) ratios that are below long-term averages. These low P/E ratios also come against the backdrop of profits that are above historical averages.

As the third-quarter earnings reporting season winds up, most companies have reported better earnings than forecast, although there were a few high-profile disappointments.

Cheap debt has been a key driver of abnormally high profits, and the steep rise in corporate bond yields will have a negative impact if sustained. That said, the outlook for global growth remains strong, with global GDP forecast to grow 3.1% in 2007 and 2008 (source: Moody’s

These figures could be hit if further weakening in the housing market and financial markets in general causes a worsening slowdown in America. However, consumer spending has not been substantially hurt, and the consensus view is that it will remain supported by strong labour markets and interest rate cuts.

One key knock-on effect of the recent distressed selling, rising volatility and the high degree of uncertainty has been that investors are demanding a higher premium for all kinds of risk. Irrespective of the outlook for corporate profits, one key question for equity markets is whether this sudden adjustment in valuations will be temporary or more long-lasting.

For the market as a whole, investors can take comfort in the fact that most gains in equity markets over the past several years have been driven by rising profits, with little change in P/E ratios. The extent of the credit crunch that is rocking financial markets, and the extent of the knock-on effect to consumer and business confidence is impossible to predict.

The sharp correction that came in July and August may not be over yet and volatility may remain high in the short to medium term. However, barring a worse impact on global growth than current consensus forecasts suggest, the downside should be limited, given that P/E ratios are not stretched and profits in general are expected to remain strong.