Market View - February 2011

"Practice 'safe spread', fear the devil, and avoid the barbershop" is the closing advice of Bill Gross, Managing Director of PIMCO (one of the biggest global bond fund managers) in his February commentary!

It sums up the parlous state of government debt markets such as US Treasuries and UK Gilts, an asset class traditionally associated with attractive yields and low risk; effectively a most attractive potential investment for the risk averse portfolio but not anymore. Gross explained, "Central bankers have lowered the cost of money for 30 years now, legitimately following global disinflationary forces downward, but also validating increased leverage via lower interest rates. Today’s rock-bottom yields, however, have less to do with disinflation and more to do with providing fuel for an asset based economy that promotes unsustainable wealth creation and a false confidence in perpetual capital gains".

Strong words indeed from one of the US’ most successful fund managers who goes on to say "It is still possible to produce 4-5% returns from a conservatively positioned bond portfolio – you just have to do it with a different mix of global assets". How very true as there are certainly some attractive propositions in both investment grade corporate bonds and in the debt markets of emerging market governments whom have not had to make a bargain with the devil and sacrifice their bond markets in order to bail out their irresponsible banks as Bill Gross so rightly claims.

Following the heartwarming seasonal rally in global markets at the end of 2010, January saw a return of volatility in certain sectors and old familiar headwinds such as Euro Sovereign debt concerns, and energy and food inflationary threats to emerging market economies once more come to the fore, in addition to the UK recovery stalling due to the "wrong kind of snow" in the fourth quarter as GDP contracted 0.5%! Nevertheless, global equities rose more than 2% as measured by the MSCI World index but there were huge disparities within those numbers with the US (S&P 500) gaining 2.36%, the UK (FTSE 100) falling 0.63% and India (MSCI) falling 10.63%!

Of course when it comes to investing, being able to properly evaluate risk is paramount to success, and the average person's difficulties in overcoming hard-wired assumptions when it comes to risk and probability is highlighted by the following example from an excellent book written by John Lanchester on the credit crunch called "Whoops". A group of doctors was asked "If a test for a certain disease is 95% accurate, and the disease affects one person in a thousand, and you go for a test and it comes back positive, what's the probability that you have the disease?"

Interestingly the vast majority reasoned the test was accurate and therefore the answer was 95%, whereas in fact the correct answer is 2% since if you test 1000 people, you will get 50 positive results whereas only one of these actually has the disease! Lanchester refers to the Nobel Prize winning research done by two Israeli psychologist-economists, Daniel Kahneman and Amos Tversky studying "the susceptibility to erroneous intuitions of intelligent, sophisticated and perceptive individuals".

The book touches upon the average person's acceptance of the influence of non-rational, non economic forces on economic thinking in contrast to the economic profession itself which is split between economic rationalists in the Milton Friedman tradition and economic liberals in the tradition of Keynes and the subject of strict rationality is the occasion of a permanent pitched battle! For now the Keynesians are prevailing in the all important theatre of the US economy as evidenced by the current round of quantitative easing QE2, and even talk of another based upon the following wire from Reuters in early February, "The Federal Reserve could debate extending its bond-buying program beyond June if U.S. economic data prove weaker than policymakers expect, Kansas City Fed President Thomas Hoenig said. Another round of bond buying "may get discussed" if the numbers look "disappointing,"

This is all rather worrying longer term from an inflationary perspective and confirms the reservations that commentators such as Bill Gross of PIMCO have about the wisdom of investing in the debt of Western governments. Fortunately global equity markets look especially attractive from a value perspective and offer potentially good rewards even in higher inflationary environments, with for example the yield at the end of January on the FTSE UK All Cap of 3.0% which compares favorably to the 3.65% on the UK 10 Year Gilt and the 3.38% available on the US 10 Year Treasury!

When you factor in especially in the Western economies of the US, UK and Europe the potential for dividend growth and for corporate earnings to grow appreciatively, the prospects for 2011 appear very bright indeed!