Citywire Video 24th June 2009

The Exchange Traded Fund (ETF) market is a rapidly growing industry. I have used ETFs in managing portfolios for many years to access equities and other asset classes including, gold, oil & property. This interview recorded recently discusses why I and other industry colleagues are such big fans of this market.

Heads or tails?

In stark contrast to the beginning of the year, when stock markets wouldn't stop falling, we are now seeing the opposite. It seems like only yesterday that we were fearing a banking collapse, the end of capitalism as we know it and the prospect of becoming the sequel to the Great Depression of 1930's. Peoples’ perceptions about the depth and severity of this recession seem to change on the flip of a coin at the moment. One minute the economy is free falling, the next it is skyrocketing towards recovery. The impact on investor sentiment has been marked. There has been a complete change from deep pessimism to hope and optimism. No doubt largely brought about by the massive amount of stimulus by governments and banks around the world to fight recession and deflation.

The recent stock market rally does seem somewhat at odds with the current health of the economy. The debate continues on about whether we are really seeing green shoots or are they just dandelions, very pretty, but at the end of the day, just weeds. Yes, it is true that more companies are reporting better than expected profits this year but this has been achieved mainly through cutting the work force and other costs. Shareholders are very supportive of companies following a lean strategy into the next economic upturn, as it will certainly be beneficial to them. However, to believe that the future upturn will be as robust as it has been over the past ten years would be foolish given the burden of rising unemployment, greater debt and an increasing savings rate. Companies in the future will just have to learn how to make money in an economy which merely trots rather than gallops.

To us though, the bigger issue is the UK’s credit rating. Last month the credit ratings agency, Standard & Poor’s, announced they had downgraded the UK's credit outlook to negative from stable. This comes at a time when the political system is in tatters. The disclosure of MPs’ expense claims for second homes, cleaning, food allowances and specialist plumbing have seriously dented their integrity and outraged the voting public. Furthermore the current government maybe in office but they seem to be losing their power. Some say a change of leadership is now required but there is yet to be a serious challenger to Gordon Brown. The potential damage to the UK’s finances and reputation is real. The cost of losing AAA credit rating would be a higher yield, an even bigger penalty to the UK’s taxpayers. Normally this would put pressure on sterling but the truth is that most G10 countries are experiencing challenges of their own in this global fight against recession and deflation.

Looking ahead, the worse may well be behind us but there is no official confirmation that this recession is over. Much of the future lower economic growth may well be reflected in current prices. It is all too easy for investors to get dragged into the day to day short term thinking of a trader when they are constantly bombarded with financial news. However, more than ever, it is essential that investors keep in mind their longer time horizon and this will inevitably drive the construction of portfolios with an equity bias. In terms of valuing equities long term, the Price Earnings Ratio (PER) has historically been a good guide. The chart above plots the starting PER against the annualised real return over the following ten years. Today it shows good value, with the current PER being around 8 to 9 it could be an attractive entry point for investors. So if we are in a position to expect double digit returns from equities, what about bonds? A basic approach to estimating the future return of bonds is to look at the current yield of a ten year gilt. That would show a return of a little over 3.0% if held to maturity without protection against inflation.

This is a fast changing investment environment and will we continue to see more opportunities and challenges to come. We believe the best opportunities will be found in the economies of Asia and other Emerging Markets which can recover faster than the debt laden western economies. Commodities can resume their long term bull market thanks to the growing middle class and infrastructure spend in these developing countries. A weak economic environment together with low inflation and quantitative easing is supportive for gilts but the government's balance sheet is weak and further issuance would be a concern. Corporate bonds look more attractive, with spreads pricing in much of the bad news. Indeed, with equities beginning to look a little overbought at present, we are reviewing whether to take some profits and rotate more into this less risky asset class. We continue to weigh up how best to invest our managed portfolios in the months ahead and wrestle with the decision of when to buy and when to wait for a better opportunity.

John Husselbee
North
9th June 2009