Market View - June 2011

“You can fool some of the people all of the time, and you can fool all of the people some of the time, but you cannot fool all of the people all of the time!” a famous line attributed to legendary US President Abraham Lincoln.

It appears an apt summary to two major recent events in financial markets. Firstly Lincoln’s pearls of wisdom were brought home loud and clear on May the 11th for Raj Rajaratnam the larger than life Head of the Galleon Hedge Fund Group when he was found guilty on all 14 counts of conspiracy and securities fraud news, which should send out a clear message from the Securities and Exchange Commission to all insider dealers in financial markets. Secondly and even more importantly global equity and bond markets appeared to also wake up to the realisation that in America, the Federal Reserve Bank is due to cease its current quantitative easing programme (QE2) at the end of June!

Over the past nine months the synthetic creation of 600 billion additional dollars by the Fed to purchase US Government Debt has helped keep both short and long term interest rates at near record lows and has injected much needed liquidity into all asset classes including global equities and commodities (currently there is around $250 billion invested in this asset class compared to just $82 billion at the end of 2008).

Critics have argued that the creation of so much liquidity has also fueled food and energy inflation which can be a major problem for those emerging economies such as China and India where these basic requirements constitute a large percentage of the daily budget! While QE2 and its predecessors in the US and Europe have undoubtedly ensured the deflationary nightmare of the 1930’s depression era has not materialised on this occasion, the quantitative easing programmes have undoubtedly also helped drive global equities (and commodities too) substantially higher from their post Lehman Brothers low with the S&P 500 in the US for example up around 100% since hitting 667 in March 2009!

However it has not come without a cost as the outstanding budget deficit of the US and other Western economies has soared! With economic data remaining anemic at best, many commentators are convinced that despite continued denial by the authorities, it is only a question of when and not if, that we will see QE3 introduced by the Federal Reserve to further bolster the US economy!

We are persuaded that further quantitative easing is indeed likely to follow, albeit possibly not until the Federal Reserve has stood back for a brief period following the end of QE2 to evaluate the impact of temporarily taking the medicine away! Meanwhile we continue to favour equities remembering the well worn adage “A Bull Market Climbs a Wall of Worry”, which globally there remains plenty of, with the renewed threat of Greek debt default risk, and the contagion risk to other European debt therein, the fear of double dip recession in the US as the housing market continues to falter and new job starts massively disappoint, while in China, there are reports that rising wages and commodity prices have begun to eat into profit margins!

Despite these and other gloomy reports, the fact remains that on traditional measures (e.g. PE and PB), the S&P 500 is the cheapest it has been for twenty years, if you exclude the exceptional valuations that occurred at the bottom of the 2008-9 bear market! Similarly in the UK market, especially when looking at stocks from a yield perspective (compared to cash and bond alternatives), there exist some very attractive medium and longer term value opportunities.

Despite the UK (FTSE down 1.32%) and US (S&P 500 down 1.35%) markets falling during May and some other markets being sold off quite aggressively (e.g. in China the Shanghai Composite was down 5.77%!), we remain upbeat that by the end of summer, equity markets should be higher as a result of the likely arrival of QE3 (possibly to materialise in the second half of this year), and the realisation by global investors of the exceptional value certain sectors of the equity market still offer!