Markets started the year on the wrong foot, spiralling lower through both January and February. While the magnitude of the falls in stockmarkets was little different to that experienced during last year’s short lived summer sell off, on this occasion the declines were corroborated by moves in credit and government bond markets. This could indicate that all is not well in the global economy but as yet, there is little confirmatory evidence to support the view that economies are sinking into recession. As Nobel Laureate Paul Samuelson once quipped, “stockmarkets have predicted nine out of the last five recessions”. Fingers crossed, this will prove to be another false alarm.
Defining exactly what sort of market sell off constitutes a recession warning is nigh on impossible. The FT ran some numbers recently and came to the conclusion that around 60% of sell offs of this magnitude presaged a recession. While being far from perfect, this is a far better forecasting record than can be claimed by virtually any economist. Our central case is that we are not in a recession but remain mired in a stuttering recovery where growth and inflation are difficult to generate.
Markets reached an inflection point in mid February and our decision then to lift the risk profile of our portfolios now appears judicious. Pleasingly, some of the bond funds that we purchased last year are now turning into profit and we think there are some attractive opportunities within sections of the fixed income market. A number of the managers that we speak with have observed that many short term traders have closed out of the positions that had run so well last year. We believe that this rally still has further to run and it is not just being powered by the technical traders, nevertheless sentiment is vulnerable to negative developments on a number of fronts.
Emerging markets appear to be turning the corner following an extended period out of favour. We are seeing a pickup in bonds and currencies within these regions and the equity market so far this year has been one of the strongest that we follow. From the market aggregates that we follow, valuation ratios are towards the low end of the range, and returns on capital and equity finally are showing signs of stabilisation. One of the highly regarded managers that we follow has recently halved the cash positions in his fund, having run 10% in cash for a protracted period. While encouraging, we feel that it is too early to be extending exposure, especially as we have just lifted the risk within the developed market equity funds that we hold. The situation in China remains as opaque as ever but the recent relaxation in monetary policy should be helpful. India remains a favourite with many managers and this year should generate a growth rate that will propel it to the top of the table. Brazil and Russia remain political basket cases and their economies are in a mess but both markets are so cheap that any positive surprises could drive them sharply higher. This is an area where we should remain vigilant.
Sterling has been noticeably weaker in the foreign exchange markets this year. Much of the narrative explaining this has been centred on June’s EU referendum vote. The vote is certainly a good reason to shy away from the pound in the near term but there is a deeper seated reason why sterling may remain under pressure beyond June. The UK’s current account deficit is at a post War high. There are two main components of the current account, the balance of trade and the net investment income flows. It is the latter element that has caused the deficit to balloon. The technicalities of this do not matter much, what does matter is that the UK needs to attract around $200m of foreign currency each day for the pound to remain stable. The Brexit vote is only one reason why these flows may slow this year, the others include the apparent peaking of the London property market and the weak oil price curtailing the recycling of petrodollars. However, a weaker pound will lift the value of the overseas holdings in your portfolio. In addition, many UK listed shares have significant overseas revenues, these too will become more valuable as sterling depreciates.
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