Market View - March 2010

Is the Sovereign Debt Emperor wearing any clothes?

A pessimist may well conclude that the United States, United Kingdom, and several major European states are technically bankrupt and will have difficulty servicing their debt going forward unless drastic remedial action is taken. The folly of generations of politicians in promising jam tomorrow through generous unfunded pension and benefits arrangements for the public sector has been laid bare for all to see as the piper begins to call his dues.

The fuse of this economic time bomb has of course been shortened further by the credit crunch and resultant decision by central banks and governments to committing trillions of taxpayers' money to bail out the irresponsible and reckless Western banks. The end result is almost the perfect storm that is currently chipping away at market confidence.

Quantitative easing which in essence is the old fashioned printing of money has temporarily helped keep long term interest rates down as the Federal Reserve, the Bank of England, and other central banks have used this mechanism to purchase billions of their respective governments' debt. However longer term, quantitative easing is likely to create inflationary pressures which will further exacerbate the sovereign debt funding issues.

Ultimately these inflationary pressures will be bound to impact upon most investment asset classes but most profoundly on government bonds and cash deposits as their real inflation adjusted values decline. Equities on the other hand always do well in inflationary periods or at least during the initial stages, while gold and inflation linked bonds are the preferred substitutes for cash within risk averse portfolios.

The post credit crunch global equity rally which began in Western markets last March (some of the emerging markets such as China had bottomed in November of 2008) has seen the S&P 500 in the US grow by more than 50% while the FTSE 100 in the UK and the FTSE EuroTop 100 are both up almost 40% over the past twelve months. During February, the global equity "pullback" which had begun in mid January continued initially on the back of continued European Sovereign debt and Chinese overheating concerns before markets rallied towards the end of the month on the back of more positive earnings from the US corporate sector.

"Investors who do best from equities are those whom can afford to be patient and a take a long term view"; so concludes a fascinating article which recently appeared in The Economist magazine titled "The very long view" which looks at data from the latest Barclays Equity Gilt study.  While this of course should make perfect sense, it is not that simplistic since valuations at the time of investment can inevitably have a huge impact upon eventual gains, but maybe somewhat surprisingly so does demography!

Research into the latter shows that the great twenty year bull market in the US, UK and Europe which began in 1981 had a strong correlation with the relative number of high earners aged between 35 and 54. As this generation of so called "baby boomers" (born in the decade or so following the Second World War) approached retirement in large numbers from 1999 onwards, they increasingly started to disinvest from equities into less riskier assets such as government bonds and cash.

The article concludes "The bad news is that the demographic maths imply that equity valuations will continue to fall until the middle of this decade. The news is even worse for government bonds. A similar model suggests that yields in both America and Britain are heading for 10% by 2020."

More than ever asset allocation decisions and their timing within portfolios will determine how successful returns will be for a given level of risk. Spring may officially have arrived but markets are likely to continue chilling the expectations of unwary investors!