Investment comment

With a large part of the alphabet having been exhausted earlier in the year in the creation of acronyms for policymakers' various economic and financial-market stimulus plans, market commentators used many of the remaining letters during the second quarter in conjecture about the 'shape' of the prospective recovery in the world economy. 'V' was the letter of choice for early-quarter optimists, but investors appeared later to be troubled by the prospect of a less aesthetically pleasing outcome; perhaps the economy was destined for a 'W'-shaped or 'double-dip' recession or a slothful, 'L'-shaped path, in which economic activity would stabilize but fail to improve from depressed levels.

Essentially, the quarter brought evidence that the pace of economic decline had slowed, but reports did little to suggest that economies were actually returning to growth. Indicators and surveys were generally less weak than previously in all the principal economic regions, but they pointed nonetheless to continued contraction, with China's being the only major economy in which growth appeared to be evident.

Improving conditions in credit markets provided support to equity markets, with the weakness of the U.S. dollar and the fall in interbank borrowing rates providing some evidence that the more than 650 global policy initiatives implemented since the beginning of the credit crisis to ease economic and financial-market strains had allowed 'liquidity' to flow more effectively through the global financial system. Investors were buoyed also by relief that the capital shortfalls identified by the U.S. government's 'stress tests' of the large U.S. banks were not as large as some had feared; and the repayment of TARP (Troubled Asset Relief Program) funds by ten U.S. financial groups also appeared to confirm the more stable condition of the financial sector.

In capital markets, a number of successful rights issues provided encouragement to equity investors about the ability of companies to raise funds and, according to Dealogic, non-financial groups raised $892 billion in the bond markets in the first half of the year (64% more than during the same period last year). Nonetheless, improved financing activity failed to be translated into increased merger and acquisition activity, with the volume of deals falling short of its (already muted) first-quarter level. Greater activity was seen in the football world, with Real Madrid bucking the equitymarket trend by buying Cristiano Ronaldo from Manchester United for a world-record transfer fee of $132 million (and Brazilian playmaker Kaka from AC Milan for $92 million to boot).

Notwithstanding nervousness about the economy towards the end of the quarter, investors were broadly stoical in the face of a number of potential challenges. They brushed aside news of General Motors' bankruptcy and Chrysler's filing for bankruptcy protection (with a certain Italian car manufacturer's plans to buy parts of those two ailing companies giving a whole new meaning to the expression 'Fiat money'); they seemed unperturbed by the threat of a swine flu pandemic; and a failed government bond auction in Latvia passed without causing significant distress.

Against this backdrop, government bond yields rose throughout much of the quarter, before receding in June, with the JPM Global Government Bond Index ($) returning +2.9% over the quarter (in large measure owing to the strength of other major currencies against the dollar) and -1.9% over the first half of the year. Corporate bond markets were strong, with spreads (the additional yield premia available over government bonds) narrowing significantly.

Equity markets continued to recover from their March lows, with returns in local-currency terms being universally impressive, and dollar wakness boosting returns from overseas. Accompanying a quarterly return from the North American stock market of +17.1% (+5.4% over the first six months) were dollar returns of +34.8% from emerging markets (+36.2% over the half-year), +32.0% from the Pacific ex Japan region (+29.1% over six months), +26.6% from the UK (+13.1% over six months), +25.9% from Europe (+7.7% over six months) and +23.1% from Japan (a six-month return of +2.7%).

The U.S. economy was reported to have shrunk to the end of March for three consecutive quarters for the first time since the mid-1970s; a substantial reduction of inventories and the largest fall in exports since 1971 were the chief culprits. Officials in both the U.S. administration and the Federal Reserve forecast that economic growth would be restored during the second half of this year, but barely a single indicator during the second quarter depicted improvement (as opposed to a slowing in the rate of decline). Retail sales, factory orders and unemployment, for example, all continued to worsen.

U.S. economic fortunes will be determined to a great extent by the way in which 'deleveraging' (the repayment of debt) takes place. The fate of consumers will be paramount given that consumerrelated spending accounts for 70% of U.S. economic activity. Since the start of the credit crisis in 2007, U.S. household wealth has fallen sharply, but household debt has actually risen. It is heartening that the 'future expectations' components of consumer confidence surveys have improved. However, with the housing market still weak (foreclosures are rising fast and prices continue to fall sharply) and with higher mortgage rates and gasoline prices serving to reduce disposable income, consumption is unlikely to be sufficiently strong in the months ahead to haul the U.S. economy decisively out of its slump.

Developments in the financial sector also will be crucial to the fate of the economy. In that respect the apparently improved health of the banks was encouraging but, as one Wall Street banker observed, the results of the U.S. government's 'stress tests' (which found that none of the 19 banks tested was likely to fail) were akin to a Starbucks menu (on which there are no 'shorts', just 'talls', 'grandes' and 'ventis'). In reality, despite banks' successful capital-raising activities to date, they are highly sensitive to continuing increases in unemployment and to further falls in house prices. Against the prevailing economic and financial-market backdrop, it seems likely that banks will require additional injections of capital and it is premature to suppose (as futures markets did in June) that the Federal Reserve will raise interest rates before the end of the year. In particular, the U.S. central bank has tended historically to wait for unemployment to fall substantially before initiating rate increases.

In the UK, the Governor of the Bank of England confessed that 'judging the balance of influences on the economy at the moment is extraordinarily difficult'. The economy was reported to have shrunk in the first quarter at its fastest rate since 1958 (-2.4% on the previous quarter). Despite sporadic signs of improvement, for example in relation to retail sales, house prices and surveys of business and consumer confidence, economic data released during the second quarter as a whole depicted a slowing rate of decline rather than outright improvement.

The Bank of England's foremost concern is that recovery in the economy may be impeded by the reluctance of banks to lend to households and businesses. The rate of growth of overall bank (and other financial institutions') lending has fallen sharply in recent months, providing little indication that the central bank's 'quantitative easing' program (which was expanded during the quarter via the extension of plans to buy both government and corporate debt) was having the desired impact on credit provision in the economy. Inter-bank lending rates fell over the second quarter, but in reality conditions improved only for very short-term debt and for the highest-quality borrowers.

Meanwhile, Alistair Darling, Chancellor of the Exchequer, admitted that the unexpectedly large downturn in UK economic activity to date had aggravated the state of the government's finances, although it was noteworthy that he chose in his Budget statement to attribute blame for the UK downturn to the global economic backdrop 47 times and not once to any more native a cause. The parlous state of the UK's public finances requires now that public-sector net borrowing be raised to the equivalent of 12.4% of gross domestic product this financial year (the highest level among the UK's developed-economy peers) rather than the 8% previously indicated by the Chancellor. The government's attempts to finance its profligacy have entailed already a doubling in the length of the UK tax 'code' (to 10,000 pages) since the Labour Party came to power in 1997 and there can be no assurance that the government will not indulge in a further enlargement of that tome.

The Chancellor's forecasts for economic growth are highly optimistic and so therefore is his assertion that he can halve the public-sector deficit over the next four years. In May, Standard & Poor's, the rating agency, changed its outlook on the UK from 'stable' to 'negative' and, although the UK was spared the indignity of having its 'AAA' rating withdrawn, S&P warned that it might review its decision if the government did not demonstrate a clear intention following the next general election to reduce the public debt burden. Alongside the threat of higher interest rates and weaker sterling to which the state of the UK public finances give rise, the near-term prospects of reduced government spending and higher taxes are likely to restrain the recovery of the economy as a whole.

President Trichet of the European Central Bank suggested inelegantly in May that 'the second derivative (was) changing its sign', meaning that the rate at which the European economy as a whole was contracting was falling. As in other regions, the slowing of deterioration is welcome, but Europe faces some significant challenges to the restoration of growth. Purchasing managers' surveys of manufacturing and services continue to indicate contraction, and Europe's dependence on export activity remains unfavorable given the slowing of demand beyond its frontiers. The banking sector also remains a significant source of concern given the reliance of European businesses upon banks for the majority of their debt funding.

According to the International Monetary Fund, write-downs on eurozone bank assets in 2009 and 2010 are likely to total $750 billion, compared with 'just' $550 billion in the U.S. In contrast with the U.S. and the UK, Continental European banks have not been subject to 'stress tests', which has created unease about their capital positions and cast a long shadow over the region's economies. Having decided against testing the stresses of banks, the European Central Bank has at least taken expansive steps to ease those stresses; it cut its main interest rate to 1% in May and announced in June that it would provide unlimited one-year funds to commercial banks at a rate of 1%. The ECB signalled with its June announcement that further rate cuts were unlikely and that subsequent one-year operations might be priced at higher rates of interest. As the Financial Times remarked, only a banker 'with a rock for a head' would refuse funds on the terms offered. However, it remains to be seen whether banks pass on the benefits of the ECB's munificence to private borrowers (and provide thereby the economic boost that the central bank hopes to deliver).

The IMF and the European Commission suggested that Europe's economy would not see recovery until 2010, and that even then improvement would be gradual. It is difficult to take a much more optimistic view than that, but the strong findings of recent business and consumer confidence surveys nonetheless are encouraging. Furthermore, unless inflation pressures mount, it is probable that European fiscal and monetary policymakers will be reluctant in the near term to scale back their efforts to shore up the region's economies and financial markets.

In Japan, the economy was reported to have contracted at an annualized rate of 15.2% in the first quarter. Exports continued to decline sharply as the country suffered its first annual trade deficit in almost 30 years, but weak domestic activity was actually more damaging. The second quarter is likely to see some improvement given the magnitude of the government's fiscal stimulus plan and the depletion of corporate inventories. However, the near-term advance may be modest compared with the extent of the preceding downturn. Even the largest monthly increases in industrial production for 56 years in both April and May were modest against previous falls, and the ever-faster decline in the value of Japanese exports will remain a serious hindrance to overall recovery.

The government's expenditure program, which covers schools, hospitals, urban infrastructure and earthquake-proofing will provide the biggest fiscal boost (as a share of economic output) of any developed economy this year, but even such seismic defences are likely to be vulnerable to the weakness of demand. With public debt approaching 200% of gross domestic product, Japan has scant room for further fiscal stimulus and, with export markets frail, demand must soon be generated locally to revive an economy whose nominal output is now back at 1992 levels. Economic activity across the Asia-Pacific region has deteriorated as sharply in recent quarters as during the Asian financial crisis of 1998. China and India have remained notable engines of growth, but elsewhere economies have generally contracted. The limitations of a mercantilist approach to economic growth have been exposed as exports have fallen significantly, but in most countries in the region falling domestic demand has actually had the greater impact.

In China, the economy was reported to have grown by 6.1% in the first quarter of 2009, aided in large part by an enormous government spending program and by the opening of credit sluice gates by the state-controlled banks. Chinese banks lent more in the first quarter of the year than in the whole of 2008 but, while such rampant lending should continue to buttress the fortunes of the economy, it may cause difficulties for the banks in future, given the likelihood that some of the lending has been misallocated and is likely to turn 'bad' as a consequence.

More widely, tax cuts and government spending programmes are likely to have a positive impact across Asia, not least because levels of indebtedness among Asian households and businesses are generally very low (allowing higher levels of disposable income to be spent rather than saved). With export markets likely to remain subdued around the world, the recovery in Asian economies would seem to rest to a great extent on the success of authorities' measures to arouse domestic spending.

Although the region continued to grapple during the second quarter with the question of how to solve a problem like North Korea, political developments were generally favorable to the fortunes of Asian economies. Relations between Taiwan and China improved, the Congress Party (perceived to be market-friendly) won an unexpectedly large number of seats in India's general election and there was an apparent end to hostilities in Sri Lanka.

Emerging economies seem certain to play an increasingly important role in the destiny of the global economy as a whole, with the first summit of the 'BRIC' countries' (Brazil, Russia, India and China's) leaders in Yekaterinburg in the Ural Mountains in June being symbolic of the development of that trend. Within the combined group of 'emerging economies', there are of course diverse patterns of activity; Brazil, India and China are far stronger at present than the economies of Eastern Europe for example. However, many of the emerging economies are likely to grow at a much faster rate than their developed counterparts in the months (if not years) ahead.

In particular, a number of emerging economies ought to benefit from their accumulation over recent years of foreign exchange reserves, which should allow them to cope with a deteriorating 'external' environment by stimulating demand in their domestic economies. In Latin America, perhaps most notably, large currency reserves, vast natural resources and sizeable consumer markets augur well for the region's future prospects.

Government bond markets weakened in local currency terms during the second quarter, with improvement in financial conditions and less weak economic statistics reducing investors' inclination to hold 'safe-haven' assets. Concern about the inflation implications of quantitative easing programmes in the U.S. and the UK appeared modest (on the evidence of break-even rates on inflation-linked government bonds), but anxiety about increases in government debt burdens may well have contributed to the rise in sovereign yields. To the U.S. investor, the weakness of the dollar gave rise to a positive return nonetheless from government bonds in dollar terms.

To date, auctions of bonds by the major governments around the world have been carried out reasonably successfully, but governments may find it challenging (in spite of central banks' monetary-policy-related purchases of their debt) to ensure that markets continue to absorb their burgeoning supplies of bonds. The sale of $8,000 billion of U.S. Treasuries (in gross terms) this year, for example, far outweighs the Federal Reserve's planned purchases of $300 billion. In the UK, extraordinarily, the cost of insuring government debt (via credit default swaps) has remained well above that of insuring the debt of Cadbury throughout this year. Investors fear perhaps that the UK government's finances are flakier than those of the confectioner.

Over the coming months, government bond investors' attention is likely to focus both on how central banks manage (and later withdraw) their support for bond markets and on how governments seek to bring ballooning budget deficits back under control. Amid uncertainties about both those factors (and about the outlook for economies and financial markets more generally), government bond markets may well be volatile in the period ahead.

The goose for government bond markets (of improving financial market conditions and less alarming economic news) proved to be the gander for corporate bond markets, with the slowdown in the rate of deterioration of most economic indicators being seen as the portent of improving corporate health. Nonetheless, the fortunes of corporate bond investors have been akin to the walker of a coastal path who finds that, having navigated a rugged cove, he has made merely a few yards' progress as the crow flies; investment-grade spreads over government bonds are still far wider than their historic average level and yields have fallen only to levels that prevailed just before the collapse of Lehman Brothers in September last year.

Investors in higher-quality corporate debt may continue to prosper if economic news improves, but they will need to be mindful of events in government bond markets, to which the pricing of their investments is closely linked. A rise in government yields (whether caused by stronger than anticipated economic recovery, concerns about escalating issuance or rising inflation) could act as a countervailing influence on their holdings. In 'high-yield' markets, spreads have halved in many cases from their peaks, but yield levels still indicate 'distress' and investors should be mindful that, with many lower-quality companies having to refinance in the months ahead, it may be too early to be sanguine about the outlook for defaults.

The North American equity market rallied strongly during the second quarter, buoyed by less deleterious economic news and by surprisingly robust corporate results; notwithstanding the fact that first-quarter earnings of the S&P 500 Index constituents fell by 34%, two-thirds of companies exceeded (already gloomy) expectations.

From an overall market perspective, 'traveling' may prove to have been more enjoyable than 'arriving', given that U.S. equity rallies tend to fade before economic recovery is entrenched (and specifically once the new orders component of the widely followed Institute for Supply Management survey reaches a level of 50, which it did in May). North American equities now trade on 'cycle-adjusted' valuations that are consistent with their long-term average over the last century but, disconcertingly, U.S. directors have recently been selling large quantities of their own stock. In identifying opportunities against a challenging economic backdrop and amid great uncertainty about the pace and extent of the 'deleveraging' of the economy, a discerning, active approach to stockmarket investing appears to be favorable to faith that the market as a whole will make significant progress in the months ahead.

The UK stock market posted its largest monthly gain for six years in April and, despite a retreat in share prices during June, it delivered a quarterly return of +26.6% in dollar terms. With the banking sector apparently stabilized, share prices should be less volatile in the months ahead than they were during much of the last year, but equity investors are beholden nonetheless to an acutely uncertain economic outlook and to material threats in relation to the UK's fiscal position. In broad terms, slower economic growth, higher financing costs and increased taxation and government regulation are likely to inhibit corporate profitability in comparison with recent years.

However, changes in share prices since the turn of the year have not been uniform and, with valuations widely dispersed, there should be ample opportunities for the active investor to identify attractively priced prospects among UK equities. In the all change world of tighter credit conditions, companies with strong balance sheets and healthy cash flows that support attractive dividends should be sought in particular.

In Europe, economic malaise and the fragility of the banking sector may seem to provide an inauspicious backdrop to equity investment. However, the unprecedented actions of fiscal and monetary authorities should be supportive of stock-market valuations that appear to reflect the likelihood that economic growth will be subdued for some time in the aftermath of the global credit crisis. Investors should not be dissuaded therefore from seeking opportunities to invest in the region's companies. Large European companies are generally well diversified in terms of their global geographic exposure and many will benefit in particular from their trading relations with the faster-growing economies of the world.

Many investors have long spurned Japan as a destination for equity investment. The protracted underperformance of the stock market against other developed-world markets, political disarray, challenging demographics, a gargantuan fiscal deficit and the poor profitability of Japanese companies have provided collectively a strong pretext to deploy funds elsewhere.

During the second quarter, the stock market returned just over 20% to local (yen-based) investors, and those investors have appeared increasingly since early March to be joining their overseas counterparts in buying Japanese stocks. With around 30% of Japan's 3,820 public companies having made losses during 2008, and with the country's long-term challenges persisting, investors should exercise caution. However, Japanese companies are being compelled by the weakness of overseas demand for their products (and by a still-resilient yen) to cut their costs and become 'leaner' in nature. As they continue to do so, with equity valuations broadly attractive in a long-term context and with the government committed seemingly to underpinning share prices, investors may well reap rewards from selective investment in Japan.

The stock markets of the Asia-Pacific region rose strongly during the second quarter, and the net flow of investment funds into Asia was running during the quarter at its fastest pace for five years. Opportunities for Asian equity investment should be attractive in general given that the region's companies, on the whole (and in contrast with their peers in Europe and the U.S.), are not running with large manacles of debt around their legs. However, investors should beware the nuances of particular companies' fortunes given rating agency Standard & Poor's forecast that the number of corporate defaults in Asia this year could exceed the level reached in the Asian financial crisis of 1997-8.

Investors would be wise to exploit the greatly improved dividend-paying attributes of Asian companies. The income available from Asian equities is well-diversified and it has grown fast. Amid the uncertainties that prevail in financial markets, the receipt of dividends should be highly prized.

Collectively, emerging markets outperformed their developedworld peers over the quarter to take their gains for the first half of the year to almost 30% in local-currency terms. The stock markets of the BRIC countries in particular have received strong inflows, with investors attracted perhaps by those countries' higher economic growth rates and lower levels of indebtedness. However, despite the increasingly collaborative behavior of the BRIC governments, it is imperative to evaluate the case of investment in emerging markets on a country-specific basis. Brazil, for example, is likely to spawn a number of attractive investment opportunities given its sizeable foreign-exchange reserves, large consumer market and considerable natural resources. Russia, by comparison, may require a highly selective approach in light of its significant political risk and fragile banking system.

'Green shoots' can emerge quickly on a landscape previously ravaged by fire or volcanic eruption, but the appearance of such shoots does not make such a landscape immediately hospitable. Similarly in the global economy, there are encouraging signs that widespread policy stimulus has helped to slow the pace of decline, but there are significant challenges to the establishment of a strong and sustainable recovery.

The financial sector, too, appears some way from returning to a state of good health. The results of U.S. banks' stress tests in the second quarter of the year were largely positive, but it is too soon to conclude that the woes of the global banking industry have been overcome; banks' capital positions remain susceptible to further economic weakness and lending to businesses and consumers (other than to the highest-quality companies on a short-term basis) remains depressed.

Just as the abundance of debt and credit amplified economic activity on the way 'up', so the reluctance of banks to lend, and indeed of consumers and businesses to borrow, are likely to impair activity on the way 'down'. Past experience suggests that 'balancesheet' recessions, of which the current downturn is certainly an example, are long and that the recoveries that emerge from them are generally weak.

Equity investors are likely to require stronger indications of wellbeing in credit markets and more wholesome evidence of recovery in the global economy in order for markets to move significantly higher; the 'less weak' thesis is unlikely to sustain them indefinitely. However, 'cyclically adjusted' equity valuations are broadly reasonable in a historical context and stock markets remain attractive to the discriminating investor. With valuations widely dispersed, rigorous analysis of companies' prospects in the context of a robust, thematic investment framework is likely to be critical in taking advantage of the opportunities that exist.

"As busy brains must beat on tickle toys,

As rash invention breeds a raw device,

So sudden falls do hinder hasty joys;

And as swift baits do fleetest fish entice,

So haste makes waste, and therefore now I say,

No haste but good, where wisdom makes the way."

George Gascoigne, 'No haste but good' (1573)