08/01/2007
Conditions dictate a cautious start
New Year is an important time for fund managers. The successes, or failures, of the past 12 months are put behind them, and the investor starts again with a blank sheet. How will markets perform, which themes will add most value? In this article, we outline some of the advice to our fund managers.
The first suggestion is that portfolios should be cautious going into the spring. We would warn about taking undue exposure to those assets where the reward appears to be scant, such as the more risky equity markets, and parts of the credit and property markets. Our balanced funds are Heavy in defensive equity markets and also in global bonds; otherwise investors should start to build up some spare cash to invest at a suitable opportunity. There are three main reasons why we are watchful: structural, cyclical and behavioural.
The structural argument relates to our detailed measurement of excess liquidity in the global economy. This correlates well over time with movements in relative bond and equity market returns. Not surprisingly, liquidity was plentiful in 2003 and 2004, but since then has contracted. Currently, monetary conditions are their tightest since 2002, albeit not yet unduly so. An easy proxy for investors to monitor in coming months is the extent of the flattening of yield curves across a variety of major economies.
There are cyclical reasons as well to be cautious. While there are still divergent indications from the data, the weight of evidence is moving towards a global slowdown, rippling out from US housing into manufacturing, and from the United States into Japan and parts of Europe. We remain more downbeat than the consensus. In coming months, we would expect to see a further significant slowdown in business activity, but not to recession levels. This is partially, but not yet fully, priced into interest rate expectations and bond markets. Our research shows that such a mid-cycle pause in business activity results in greater market volatility, especially for stocks.
By no means all our concerns are economic. 2007 looks set to be a year of slower profits growth, under the impact of decelerating revenues and higher labour and debt servicing costs. We have warned that we see specific dangers for the credit markets, as default rates rise and corporate bond spreads widen out. There will always be high yield defaults, but a cluster of investment grade defaults would be worrying news especially for some of the more complex leveraged structures. Problems in this area could encourage a flight to quality.
Some reasons to be cautious therefore into the spring, but there are several reasons to be upbeat about the latter stages of 2007. Inflation remains key to this investment cycle, as the long-feared upturn in inflationary pressures would cause central banks to slam on the brakes. Our research has concluded that headline and core pressures should ease into late 2007, as long as global economic activity decelerates which in turn dampens the labour market. It must be said though that central bankers are likely to make hawkish statements for some time. After all, inflation expectations have risen in recent months and we are wary that several special factors, such as droughts, will affect headline inflation into 2007.
Another positive factor is the strength of corporate activity such as M&A or management buy outs. There were over 15,000 M&A deals globally in 2006, worth almost $2.5tn. This matched the previous peak seen in 2000. Small and medium sized firms were initially the major targets, but the deal size is beginning to rise as private equity accounts for more M&A activity. The underlying drivers are well known: profits growth has helped improve corporate balance sheets; cash flows into private equity funds have been strong as more pension schemes diversify into alternative assets; and current low financing rates enable the leveraging up such funds.
A final reason for investors to remain upbeat is the lack of barriers towards globalisation. The benefits of migration, of global trade, of cross-border capital flows, are all appearing in terms of real wages growth, the return on corporate capital, or the performance of emerging equity markets. Some politicians have undoubtedly raised a few barriers to such labour, trade or capital flows, whether in the form of US pressure on the Chinese authorities, European resistance to the take-over of ‘strategic industries', or the recent Thai attempt at defending its currency. Nevertheless, the benefits are still seen to outweigh the drawbacks.
We started with a blank sheet of paper. Already we can fill in some of the defining trends for 2007: global liquidity, the G7 business cycle, problems in credit markets, inflation, and M&A prospects. Our Focus on Change approach will help us determine how these interact, and how to respond as new trends appear. The resulting portfolio taking moderate bets should prove rewarding for the coming year.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Fund Strategy on 8 January 2007.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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