Market Outlook - Bond & Equities - Gregor Logan
After a volatile summer it now appears to be an opportune time to adopt a more contrarian approach to investing. The market has reached a pivotal point, with valuations in the consumer and interest rate sensitive areas now too cheap to ignore.
Many of New Star’s funds have already started to rotate towards stocks that are cheaply valued after a spell of underperformance, opposed to those that have rallied with the market momentum and are now looking expensive. This will be an important theme, especially if central bankers continue to ease monetary policy as has happened in the US.
The US continues to dominate the macro picture. With the chances of a US recession having risen over the summer months, the old adage that “when the US sneezes, the rest of the world catches a cold,” again becomes pertinent. It remains to be seen if the US consumer can withstand a squeeze on credit and its increase in cost as well as a possible continuation of the housing downturn, a trend that would further dent confidence. While stable labour market conditions remain and the fed funds target rate cut by the Federal Reserve in mid-September provided a boost to the consumer, there remains the possibility of a more difficult economic environment in the US than is currently being forecast.
Asia continues to provide compelling opportunities, notably in China. The Asia region, excluding Japan, is expected to expand 9.3% this year, almost twice the global average, helped by a 15.7% rise in exports. China posted 11% expansion last year, the fourth consecutive year of double-digit growth. Assuming recession is avoided in the US, emerging markets in the Far East and elsewhere should continue to do well.
There should be a modest upturn in corporate bond markets over the coming months. Government bond yields fell during the subprime crisis as people sought “safe havens” for their investments. Having begun July at 5.4% 10-year gilt yields fell to a 4.8% low in September and at the shorter end they now look quite expensive. At the same time credit spreads widened so it is anticipated that spreads will narrow again, with corporate bonds doing reasonably well and government bond yields rising modestly.
At the end of the third quarter the bullish case for equities was straightforward: valuations were low, particularly relative to bonds and cash, albeit predicated on pre-crisis earnings estimates, which may now start to come down, and speculators had built up large short positions compared with being net long before the setback started.
The bear case was equally straightforward: equity markets always suffer during recessions and recessions are caused by higher interest rates and oil prices or both. While central bankers have stopped raising rates and the Fed has already made one cut, the interbank market was not functioning properly at the quarter end so these lower rates had not yet fed through to borrowers and credit had become scarcer. In some markets, for example the UK, this pushed up mortgage costs, which, in turn, may contribute to a dampening of the housing market. In the more important US housing market, however, mortgage rates came down.
Looking ahead to the remainder of 2007, it seems that the point of maximum stress in the credit markets has passed. This may be good for equity markets because previously they have often bottomed at the beginning of a crisis, not the end, hence the recovery of recent weeks. After the big write-offs by US financial groups reporting recently, global financial stocks, which had previously fallen sharply, have begun to rally in anticipation of the worst being over. This increases the appeal of cheaply valued shares in the interest rate-sensitive financial and consumer areas.
Past performance is not necessarily a guide to future performance. The opinions expressed here represent the views of the fund manager at 19 October 2007 and should not be interpreted as investment advice. The value of investments in the funds mentioned may fall as well as rise as a result of market or exchange rate movements. This document is for professional advisers, professional investors and financial institutions only and is not to be relied upon by private investors. Issued by New Star Investment Funds Limited.
