Market View - March 2011

"Risk comes from not knowing what you are doing" is one of many common sense investment phrases attributed to the legendary "sage of Omaha" Warren Buffet, while the lesser known Charles S Sanford, Jr., Chairman of Bankers Trust in the late seventies is famous for developing the phrase "risk adjusted return on capital", and believed "successful people understand that risk, properly conceived, is often highly productive rather than something to avoid. They appreciate that risk is an advantage to be pursued rather than a pitfall to be skirted. Such people understand that taking calculated risks is quite different from being rash".

Of course both of these statements are true, and in the context of managing our investment portfolios, preserving capital, and achieving optimal returns for minimal risk, are essential considerations before every decision! On the subject of risk, it is interesting to note that according to a new book (titled Beyond Mechanical Markets: Asset Price Swings, Risk and the Role of The State) by Roman Frydman of New York University and Michael Goldberg of the University of New Hampshire, the "efficient market hypothesis" is dead; long live the "contingent market hypothesis"!

A recent Buttonwood article from The Economist newspaper (Killing off the monster) praised the efficient market hypothesis for being the catalyst that led the markets to embrace low cost index tracking funds, while blaming it for leading central banks to sit idly by while asset bubbles inflated! The Buttonwood article goes on to summarise contingent market hypothesis as "The casual process underpinning price movements depends on available information, which includes observations concerning fundamental factors specific to each market.

"This process cannot be adequately characterised by an overarching model, defined as a rule that exactly relates market outcomes to available information up to a fully pre-determined random error at all time periods, past, present and future". While concluding that only time will tell whether CMH will prove more reliable than EMH, The Economist does suggest the book's findings has one decidedly attractive recommendation, namely that central banks should intervene both on the upside as well as on the downside to limit excessive asset price swings!

Meanwhile global markets continue to be concerned by unrest in the Middle East and North Africa, and rising food and energy costs, due in part to political unrest but also to shortages caused by disruptive weather patterns resulting in failed or lower yielding crops. These factors were sighted as largely to blame for another disappointing month for emerging markets with the MSCI Emerging Markets index falling 1.01% on the back of the nearly 3% lost in January with the India market again one of the worst hit dropping 3% on the back of its 10% fall the previous month!

Nevertheless global equities otherwise were surprisingly resilient during February with the MSCI World index rising another 3.33% driven largely by the 3.20% rise in the S&P 500 on the back of growing optimism in the US that the recovery is gathering pace, while the FTSE 100 in the UK climbed a more modest 2.24%. However several renowned commentators including Bill Gross of PIMCO and Jim Rogers, the commodity bull, continue to warn of the potential repercussions of the Federal Reserve's Quantative Easing programme.

A key consideration is that the Federal Reserve through quantitative easing (or printing dollars) has been responsible for as much as 70% of recent Treasury bond purchases, while the remaining buyers have been predominantly foreign sovereigns such as China and Japan. Worryingly, of the more than $7 trillion of outstanding Treasury debt, almost 50% matures in the next three years with more than $1.7 trillion maturing this year alone and it is hard to see how in the current environment much if any of this will be bought by the domestic institutions and investors whom have traditionally been investors leaving us to wonder whether when QE2 expires in June, an even bigger QE3 programme will immediately follow?

Of course was that to be the case, the likely eventual inflationary repercussion for the US does not bear thinking about, but in the meantime, the increased liquidity caused by quantitative easing programmes from various Western governments is likely to be good news for equity investments, especially in higher yielding companies with solid business models and a history of paying increasing dividends. Global insurance companies whom reputedly manage some $22 trillion of assets appear to be in agreement on this point as a report in Financial News at the end of February suggested companies such as Swiss Re are set to switch billions from fixed income holdings into stocks to try and counter the threat of impending interest rate rises.

Additionally this year's Barclays equity gilt study has two especially intriguing observations, with the first relating to the impact of demography upon bond and equity returns. Their research suggests that the aging of the baby boomers will put additional upward pressure on bond yields while also impacting to a lesser extent on the likely equity risk premium and conclude that while they expect equities to outperform bonds (projected to grow at a nominal 6% per annum) over the next decade or so, the excess return (i.e. the annualised real return after inflation) is forecast to be around 3% and not 5% as suggested in previous editions of the Barclays study and 1% less than the historic one hundred and ten year average (i.e. 4% per annum real inflation adjusted return).

More encouraging however is the equity gilt study team's excellent in depth analysis on Emerging Markets and in its summary overview (Navigating the new EM landscape: Where to find the best returns), it says "In the six years since this series last took up emerging markets, much has changed. Global influence has moved from the slow-growing G7 to booming China, contributing to EM growth outperformance. Emerging Markets also weathered the 2008 credit crisis remarkably well, despite some initial skepticism, due predominantly to robust policy frameworks tempered in earlier booms and busts. We think investors should expect EM economies to deliver higher growth and lower volatility than in the past, improving economic Sharpe ratios relative to the lagging G4.

"Although EM growth outperformance is part of the received market wisdom, we think it is not fully priced in to today's equity markets. We forecast EM equity market returns of more than 10% (in USD adjusted for inflation), in line with the past decade's strong performance".

Ash-Ridge Asset Management is inclined to agree with most of these findings believing the best risk adjusted opportunities in 2011 will be found in a combination of higher yielding developed market equities combined with attractive growth options in emerging Asian markets!