Market View - July 2010

Concerns over global sovereign debt continued to focus the market's attention during June. This combined with worries about anaemic recovery evidence in developed economies, the fallout from the BP Gulf of Mexico oil disaster and question marks over the strength of Chinese growth reignited the threat of a double dip recession.

During June the S&P 500 in the US fell 5.39% while the FTSE 100 did just as badly falling 5.23%. The first half of 2010 has been disappointing for global equities with the FTSE All World index down 10.6% (which included the SP 500 down 7.57%, the FTSE 100 down 9.16% and the Shanghai Composite index down 27%)

On the face of it, some of the market's response to the fundamental data would suggest that it is worried about future deflation. Accordingly Treasury yields have been falling (the US 10 year bond's yield recently fell below 3%), resulting in capital values rising, and consequently US bonds (based upon a Barclays index) are up 5.8% during the first six months of 2010.

Interestingly the US dollar and gold (up 13.3%) have also risen during the first half of the year! Historically there has been an inverse relationship between the US Dollar and gold bullion, and rising gold prices would normally signify concern about future inflation.

So has Mister Market suddenly become schizophrenic, or simply lost the plot? The answer is almost certainly more the former than the latter!

The Buttonwood column in a recent edition of The Economist summed it up in an article titled "Something doesn't fit", i.e. why are both Treasury bonds (with the yield on the 10 Year recently falling below 3%) and gold (now around $1200 an ounce) both performing so well? Perceived wisdom expects gold to do well in an inflationary environment with bonds doing badly, and vice-versa in deflationary periods.

This was most starkly in evidence in 1980 when gold reached its all time inflation adjusted high and was negatively correlated with the ten year Treasury bond which was then yielding 10.8%. Market commentators appear split on the inflation/deflation conundrum which may explain the appreciation of both asset classes as investors hedge their bets.

As Bank Credit Analyst (BCA) was quoted as saying in The Economist article "the direction of official policy (low rates, quantitative easing, and big deficits) looks inflationary but the economic fundamentals (a big output gap, sluggish credit growth) look deflationary". However with market valuations in many markets including the US and Europe looking extraordinarily attractive and corporate earning expectations remaining robust, opportunities will continue to present themselves in global equities.

Accordingly asset allocation and timing remains the key to preserving capital and hopefully making some gains too.