Market View - January 2010

"Much of the past thirty years of macroeconomics was spectacularly useless at best and positively harmful at worst!"

So claimed Nobel Prize winning economist Paul Krugman when speaking at a London School of Economics lecture last summer. Both Krugman and The Economist in a subsequent article in July called into question the "efficient market theory", and in their conclusions warned that "we all need to be mindful that as experience shows, correlations can change suddenly", and that "financial economists need better theories of why liquid markets suddenly become illiquid and of how to manage the risk of moral hazard"

As we start a New Year full of hopeful expectation for financial markets, it is maybe as well to ponder Krugman's words and their implications for investing during 2010? First though it might be worth reflecting upon various asset class returns during 2009 and more importantly over the last decade?

During 2009, the FTSE World index was up 23.5% led by emerging markets such as Brazil, China and India, but over the last decade the index fell a disappointing 17.76%. If we allow for the reinvestment of dividends global equities were up 30.79% over the past twelve months and a paltry 2.34% since the beginning of 2000.

The US equity market finished the year strongly with the S&P 500 up 23.45% overall, and more than 65% since its March lows, but despite these impressive gains, US stocks are still more than 24% lower than they were at the end of 1999, making this the worst decade for returns since the 1930's! In the UK, equity returns were similar as the FTSE 100 index rose 22% in 2009 (up 54% gains since the March lows), but disappointingly (and symmetrically) the index is down almost 22% since the beginning of the decade.

Emerging market equities however would have given the investor positive returns both during 2009 and over the past decade with the MSCI index up 74.5% over the last twelve months and more than 102% since the end of 1999! Government Bonds offered the best risk adjusted returns over the decade with the JP Morgan Global Government Bond index up more than 91% (1.9% in 2009), while those investors whom were prepared to take rather more risk in fixed income would have seen returns of more than 171% from the JP Morgan Emerging Bond Index (28.17% over twelve months).

Although more recently gold bullion has captured the investing community's imagination with a very respectable return of more than 24% during 2009, and a spectacular 388% over the past ten years, many investors will be wondering whether the golden opportunity for this asset class has now gone? Money invested in Sterling denominated money market funds on the other hand would have returned less than 1% in 2009, but 38.16% over the last ten years.

So back to 2010 and the next decade and the inevitable $64,000 question of which asset class to invest in for the optimal risk return trade off? While the declining unemployment figures from the US during the last week of December when combined with this week's better than expected Purchasing managers' index reports for China, South Korea, Taiwan and India, is most encouraging news, many of the most worrisome underlying problems remain, and have the potential to make the Dubai debt debacle look like a storm in a tea cup by comparison.

Will the Federal Reserve which has already monetized around $1.7 Trillion worth of debt in the US have to continue doing so for the foreseeable future, thereby continuing to put downward pressure on the beleaguered dollar? Just as worryingly the UK government in October had to borrow £11.4 billion to meet its bills, which represents the largest amount since records began being kept in 1946, and the total public sector net debt grew to £829.7 billion or 59.2 % of national output (source, The Times), which makes one suspect the Bank of England now rues the decision a decade ago to sell so much of Britain's gold reserves at just $300 an ounce or less!

Our expectation is that the printing presses in both the US and Europe will probably continue working around the clock, and that interest rates in most developed market economies will remain at record lows for some time yet, regardless of inflationary pressures and in order to help ensure the feeble existing recovery does not become stillborn! There can be little doubt that over time these policy actions will generate inflation and that accordingly fixed income is unlikely to be anything like as attractive in the next decade as it was during the last, although there will undoubtedly be selective opportunities especially in respect to corporate debt.

With yields in the foreseeable future on cash also likely to continue to be derisory, our preferred asset class is equities, and especially in emerging markets where most countries have positive current account balances, and GDP growth is likely to remain strong due to continuing urbanization policies and the likely transitioning of many of these markets over the next decade from being largely export driven to consumption and ultimately importing economies. Finally despite the phenomenal run enjoyed by gold over the past decade, we would be surprised if the bull market in this asset class (or indeed in commodities generally) is anywhere near over as a result of the inevitable likely future inflation generated by Federal Reserve polices post the Lehman crisis!

More than ever we believe it will pay to be both well informed and well advised! We wish you a Happy and Prosperous New Year!