How will the dice fall?

The new year throws up a plethora of forecasts including optimistic predictions for global growth, with China the strongest performer. Meanwhile, the outlook for bonds and equities is less certain. By Fund Strategy writers.

Corporate earnings have also surprised on the upside. While the risk to lower grade corporates remains, there are still those who claim investment grade offers some opportunities.

“As investment becomes a hunt for yields, there will be little value in government debt markets”, says Bill O’Neill, the chief investment officer for Europe, Middle East and Africa (EMEA) at Merrill Lynch Wealth Management in the Merrill Lynch Wealth Management Year Ahead 2011. “High grade corporate bonds are another matter,” he adds. “We think they could be well-supported in the first half of 2011.”

The problem is that some claim the investment grade debt market is already presenting limited value. At current levels the dividend yield from income-producing equities looks set to outperform bonds and if consensus global growth expectations are exceeded there could also be the potential for a decent capital return from stocks relative to fixed income.

The forecasts suggest that there are several key risks for fixed income investors. While there are indicators suggesting that equities may struggle in the short term, the pitfalls for bonds have been largely underappreciated.

First, and perhaps most significantly, the scale of quantitative easing proposed by America’s Federal Reserve does not yet appear to have been fully factored in to expectations.

Legal & General, in its December Fundamentals briefing, pointed out that the stimulus simply adds more problems to the American government’s already unsustainable fiscal deficit. As a recovery in tax revenues has been deemed all the more unlikely by the recent extension of the George W Bush era tax cuts, the country’s funding requirements will have to continue to be met by foreign borrowing.

”As investment becomes a hunt for yields, there will be little value in government debt markets”

While Britain appears so far to have escaped the need for additional stimulus, it is difficult to rule out the possibility that it may be called upon as a last resort. In the medium term, therefore, concerns surrounding sovereign debt will probably cause yields to rise.

Merrill Lynch predicts that the yield on British 10-year gilts will see a 100-basis-points increase from the last quarter of 2010 to the final quarter of 2011, while 10-year Treasury yields are forecast to rise by 85 basis points. Legal & General predicts a shallower rise for 10-year gilts, averaging 70 basis points higher in 2011, while the average yield for Treasuries is seen rising by 110 basis points.

These views are not universally accepted, however. John Higgins, a senior market economist at Capital Economics, says the yield on 10-year Treasuries could drop from about 3.3% almost to 2.5% by the end of 2011. This is because proposed fiscal stimulus might supply a temporary pick-up in growth for the American economy, although this could evaporate as 2012 approaches.

On the corporate side, many groups are indicating that they could begin reversing their overweight in fixed income relative to equities in 2011. This would mean the end of a trend that has lasted for the past 10-15 years and could have huge implications for investors.

After several shocks to equity markets in recent decades, many investors have built up large overweight positions in bonds. These could start to be unwound if investors see dividend-yielding equities producing solid returns. Indeed, Morgan Stanley makes the point that one of the purposes of the ­policy of quantitative easing is to reduce the yield on government debt artificially to drive investors back into equities.

Given the tensions that are being built up in the system, however, 2011 is a ­difficult year to call. In the bear case scenario, for instance, equities could see dramatic falls, which could prove a significant boost to the price of fixed-income assets. Furthermore, the possibility of more extraordinary monetary action is already casting a cloud over the sovereign debt market.

With these problems hanging over bond markets it is logical to conclude that corporate debt is likely to enjoy a better year than its sovereign counterparts. The problem is that investors have largely appreciated this theme and have reflected this in the price of investment grade assets.

Despite the optimism surrounding emerging markets, O’Neill offers a word of warning. In his report he said that although the fiscal situation in several developing economies looks far better than for their western counterparts, investors should treat emerging market debt with caution, taking care to avoid overvalued assets.

While value may be hard to come by in corporate bond markets, investors should be conscious of the fact that the mispricing of risk was as much a factor in the 2008 crash as it was in the 2009 rally.

EQUITIES, by Will Jackson

Fund managers do not have a great track record in forecasting one-year stockmarket performance and a review of Association of Investment Companies annual polls reveals mixed results.

Only a quarter of mana­gers correctly predicted the year-end FTSE 100 value for 2007 within a band of 500 points, but they were right on the broad direction of the market. At least half the survey’s respondents forecast a rise during the following 12 months, and the market duly gained about 200 points.

Predictions over the next two years were less successful, however, as managers failed to foresee the turmoil of late 2008 and the subsequent rebound in 2009. Most respondents expected the FTSE to gain in 2008, with 17% expecting the index to break through the 7,000 mark (it fell by 2,000 points, to below 4,500). For 2009, just one-third of managers correctly predicted that the index would rise back through 5,000 points, while 5% wrongly feared a catastrophic decline, to under 2,000.

Ian Lance, an equity income portfolio manager at RWC Partners, says such predictions are hampered by three factors: markets are often driven by sentiment rather than fundamentals on a 12-month view; managers tend to “puff their own asset class to sell their product”; and being able to predict the price movements of hundreds of companies spread across different sectors is implausible. Nevertheless, analysing manager forecasts can give a general picture of their hopes and fears for the year ahead.

By considering the views of multi-asset specialists, who have no particular asset class to puff, it is also possible to mitigate the risk of overly bullish forecasts. So it is interesting to note that multi-asset managers are largely upbeat on global equities for 2011 compared with other mainstream asset types. Ashburton and PSigma Investment Management both favour stocks, for example, while Distinction Asset Management says valuations “remain undemanding” and are more attractive than bonds.

In the investment banking world, Morgan Stanley and Merrill Lynch are also sanguine on the asset class in relative terms. Both banks forecast that the equity bull market will continue and Merrill Lynch recommends that investors should have a “significant” overweight allocation to stocks. Merrill Lynch says it expects the MSCI All Countries World index to rise to 375, implying a gain of about 14% for global equities this year based on the benchmark’s value on December 22.

Quantitative easing
Among equity specialists, one of the key factors likely to affect global ­stockmarkets is quantitative easing. The Fed expanded its bond purchase programme by $600 billion last year, and some fund managers fear the extra money created will flow into emerging markets, fuelling asset bubbles. Raymond Chan, RCM’s chief investment officer for Asia Pacific, says bubbles are not yet forming, but strong capital flows could lead to inflation risks in northern Asia, in particular.

Inflows may also cause further currency appreciation in the region, and several managers are avoiding exporters and focusing on domestically-focused stocks as a result. Marino Valensise, the chief investment officer at Baring Asset Management, favours “smaller, inward-looking countries” such as Indonesia. On China, Schroders’ Asia ex Japan equities team expects the renminbi to appreciate at “a measured pace” of 3-4% a year versus the dollar and it remains wary of exporters, preferring companies with domestic revenues.

Luxury brands
The flip-side of emerging market currency appreciation is that it could support demand for western luxury brands – an investment theme touted by several fund managers. Distinction expects “tremendous” growth in the sector, and highlights BMW, Louis Vuitton Moët Hennessy (LVMH) and Tiffany. Ignis Asset Management tips LVMH, Pandora and Richemont. Threadneedle favours BMW. Standard & Poor’s lists BMW and LVMH in its top 10 European stocks for 2011.

Despite their consensus on luxury brands, Distinction and Ignis have differing views on the outlook for western financials. Distinction expects European and American banks to suffer under the weight of “stifling” regulation and recapitalisations, while James Smith, the manager of the Ignis Global Growth fund, says some ­European financials are attractively-valued following recent weakness. Banco Santander and Barclays are high-quality banks which have been “tarred with the bad financials brush”, he says.

M&A activity
In Europe stockmarkets more broadly, Ian Ormiston at Alliance Trust forecasts that “the macro noise will not abate” in 2011 as the eurozone sovereign funding crisis rumbles on.

But he also predicts that rising merger and acquisition (M&A) activity will have a positive impact, bolstering equity valuations as cash-rich companies put their reserves to work. Liontrust’s Anthony Cross expects a similar pick-up in M&A among British smaller companies, and highlights financials and media companies as attractive buys.

American M&A activity is also likely to increase, according to Schroders. Jonathan Armitage, the firm’s head of US equities, says American companies cut costs and restructured during the economic downturn, leaving their balance sheets in good shape. “Companies can either use their free cash to make acquisitions that support earnings or they can leave it on deposit where it will earn around a quarter of one percent,” he writes. “In our view, that is not a particularly difficult decision.”

One thing most commentators agree on is that the ride for equity investors this year is likely to be choppy. Mike McNaught-Davis, the head of international equities at Scottish Widows Investment Partnership, says equities will be pushed higher, fuelled by cheap valuations, low interest rates and renewed growth. However, stockmarkets are likely to be “buffeted” by developments in the eurozone debt ­crisis and concerns over Chinese inflation, he says.

Tom Becket, the chief investment officer at PSigma, notes that Stanley Druckenmiller, a high-profile hedge fund manager who helped George Soros “break” the Bank of England in the 1990s, retired last year in frustration at how volatility had affected his performance. Managers are in for little respite this year, he says.

“In 2010 it has been easy to feel like both a genius and a dunce within a matter of days,” Becket wrote in December. “But sadly our prognosis is for repeat bouts of schizophrenia in the months ahead.”