03/08/06
Investors should adopt a diversified style in difficult times
Our Perspectives articles have tried to guide investors through this year's volatile financial markets. In the early spring, we wrote about improving investor confidence as the global economy became better balanced. Later we examined the main factors causing the equity market corrections. It is worth repeating in full the conclusion to the Perspectives article in May: ‘our House View was prepared for market volatility during the spring, and we are wary of continued disturbances into the summer. We are examining yet again some of the key drivers of financial markets, but as long as the earnings cycle appears sustainable and companies remain committed to self-help initiatives to maintain profit margins, then in due course riskier assets should benefit from the continuation of this extended business cycle'.
That conclusion remains valid. Financial markets are still concerned about the next round of decisions by central banks. While the latest statement from Ben Bernanke, Chairman of the US Federal Reserve, was relatively reassuring, investors are wary about how aggressive the Bank of Japan will be after its first rate increase in six years. Expectations of a further round of tightening in China have risen markedly after the authorities announced that economic growth has reached a 12-year high. On top of that, tensions in the Middle East affect energy prices, adding to the pressures on household real incomes. Looking ahead, a major problem could be a repeat of last autumn's hurricanes reaping havoc amongst the oil and gas installations across the Gulf of Mexico.
There is a danger we become too gloomy about these pressing problems, and pay insufficient attention to the underlying positive fundamentals. The business cycle has strong momentum; brokers estimate that global growth has been about 4.0-4.5%pa in the first half of this year. Good top-line growth is feeding company profits with early indications that US firms are on course for 12%pa earnings in the second quarter. This is important as it means company balance sheets are still strong, enabling them to withstand the pressures we have been discussing. Indeed, a noticeable feature of recent weeks was how well the corporate bond markets behaved during the correction in equity markets.
Where next? We analysed a number of investment issues in our recent Global Outlook publication. The world economy has become more integrated in recent years, although globalisation opens up both pitfalls as well as opportunities for UK based investors. One conclusion of our research is that investors need to assess how their portfolios are exposed to both domestic and overseas sales. The UK stock market is more open than many, with about 45% of the sales of companies quoted in the UK coming from domestic operations and the remaining 55% from overseas. In contrast, only 30-35% of the sales of US and European firms come from overseas, while in the case of Japan the figure is as low as 11%. By buying into other markets, UK based investors can selectively raise exposures to the domestic sectors of overseas economies, which could prove beneficial to their portfolios. For instance, there are signs of recovery in Japanese and European consumption. In the US, by contrast, consumers are widely expected to slow their discretionary purchases against a backdrop of slowing house prices and rising fuel costs. Similar arguments for diversifying investment exposure can be made based on market composition; as is well known, the UK market is biased towards resources and financials, but less exposed than its counterparts to more cyclical areas such as technology and industrials.
Our Global Outlook analysis also showed another consequence of global integration, a stronger correlation between economic cycles and between asset prices. The world's three largest stock markets have been moving in the same direction, albeit at different rates and with variable contributions from currencies. Directional correlation has been measured at 87% over the last five years, compared to only 39% for the five years before that. This is not only an issue affecting equities. Low and stable inflation has meant that bond markets are strongly linked with investors' expectations about the direction of US monetary policy, despite the different growth and inflation dynamics we are seeing in Europe and Japan for example.
Asset correlations have been rising for a number of years but may not persist, perhaps under the challenge of rising volatility. Anyone of such a view may wish to pursue a more differentiated investment approach going forward - opportunities may still be found to reflect risk preferences and investment views via stock selection, or sector and asset allocation in actively managed portfolios.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Professional Adviser on 3 August 2006
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