Market View - September 2010

"Be fearful when others are greedy and be greedy when others are fearful" is a well known saying of Warren Buffet that investors forget all too easily when markets behave as they did in August!

"Be fearful when others are greedy and be greedy when others are fearful" is a well known saying of Warren Buffet that investors forget all too easily when markets behave as they did in August!

Last month global markets slid once more as fears about the strength and durability of the economic recovery combined with uncertainty as to whether deflation or inflation is the greater threat to future prosperity? This is the key question which is focusing everybody's attention including the central banks and renowned global economists, whom appear unable to agree as to what actions the Federal Reserve should take to stimulate the economy and help end the great recession.

Raghuram Rajan, former Chief Economist at the International Monetary Fund and William White, the former Head of the Bank of International Settlements' monetary and economic department have been telling Bernanke he must raise interest rates to avoid creating new asset bubbles and ensure a more efficient economy (source Bloomberg). However Anatole Kaletsky, Chief Economist of The (London) Times has long advocated keeping interest rates (both short and long) at near zero for several years, while Nobel prize winning economist Paul Krugman of the New York Times believes the actions Rajan and White advocate in the light of such high unemployment, namely raising rates by 2% would be madness, but he is highly critical of the Fed for its wait and see policy and the deflationary risks that they run with that approach quoting "The Fed had studied Japan extensively, and believed that the Bank of Japan could have averted the lost decade if it had reacted very aggressively early on"

Certainly the performance of various indices and sectors makes pretty gloomy reading so far in 2010 with the S&P 500 down almost 6% and the FTSE 100 nearly 4%. Corporate bonds however and selective emerging market equity and bond investments have been more rewarding and remind us that financial markets are not a "random walk" and exploitable opportunities will always be present regardless of how gloomy the global economy may seem.

Last month China officially overtook Japan as the world's second largest economy, and a recent article in the Economist (Contest of the century) reminded us that until 1800 the Land of the Dragon and its Indian neighbour made up half the world economy! It would seem the future is destined to be dominated by these two once again, which was reaffirmed with news that India's economy grew by 8.8% annualized during the second quarter!

Going forward we continue to favour equities as our preferred asset class as we believe they are priced to deliver attractive returns (the implied equity risk premium on the S&P 500 in the US is at around 6%), while the likelihood is of low returns from government bonds and most (investment grade) corporate bonds, although selective opportunities may exist in the high yield sector. The additional factor in favour of equities is the current negative sentiment as seen in the outflows from equity investments in the US with data from the Investment Company Institute showing that $33 billion left domestic stock market mutual funds in the first seven months of 2010, while more than $185 billion was invested into bond mutual funds.

Historically these flow trends have often been excellent contrary indicators reminding us once again of Buffet's prophetic pearls of wisdom quoted at the top of our commentary!