Investment Review

Risk assets performed strongly in March supported by generally upbeat economic data and an explicit safety net provided to Greece by the European Union. The global economic recovery appears to be on track, with the wobble last month looking to be more related to adverse weather, rather than any serious faltering in the global economy. The recovery remains tepid in the developed economies but robust in the emerging economies, and equity markets have also been supported by a remarkable rebound in profit margins.

Most importantly, it appears that the impetus for global growth is transitioning from fiscal stimulus and inventory rebuilding to a self-sustaining recovery. In particular, labour market indicators continue to improve gradually (as shown in the chart of US non-farm payrolls below), consumption spending is growing at a modest pace and business fixed investment is accelerating notably outside the ongoing train wreck that is the construction sector.

The strength of corporate balance sheets and cash flows together with the rebuilding of household savings provide reasonable grounds for optimism about the sustainability of the recovery into 2011. Indeed, there is some upside risk to the global recovery due to the high degree of synchronisation (which, of course, was a key feature exacerbating the depth of the recession).

Nonetheless, at this stage global economic activity remains well below the peak reached in early 2008, owing to the deep recession followed by generally insipid recoveries in the developed world – most notably in the Euro-area, UK and Japan. As a result, disinflationary pressures remain overwhelming in the major developed economies. At the same time, the emerging economies are growing very strongly with inflationary pressures in these economies likely to be a feature for some years as interest rates remain very low and currency appreciation is generally resisted. The wider ramifications of this widely divergent economic performance between the developed and developing economies will be a key feature of the investment landscape for many years. One issue which arises as a result is the ongoing unresolved trade tensions between the US and China. Our working assumption is that these issues will be managed without a major flare up in trade protectionism, but the downside risks for the global economy are clear.

Another downside risk for the global economy remains the fiscal imbalances in many of the major developed economies. Fiscal tightening will need to be a part of the landscape for many years to come and will constitute an ongoing drag on global economic growth. To the extent that it does not occur, there must be significant upside risk to global bond yields which, in turn, would undermine the outlook for growth and also drag down the rating of the equity market and other risk assets. A key judgement will be the extent to which global bond markets will need to riot to secure the necessary tightening of fiscal policy. One obvious possibility for such a sell-off is right now – bond markets are faced with the likely end of quantitative easing in the US and the UK which changes the supply/demand balance in debt markets at the same time as Greece faces her peak funding demands. A further flashpoint will be as the global private sector recovers and borrowing needs increase commensurately. Suffice to say, notwithstanding an extremely disinflationary backdrop for the next couple of years in the major developed economies, and very steep yield curves, we remain bearish on global government bonds.

Within the major developed countries, the US economy stands out as the best performer. Ironically enough, given the origins of the financial crisis, the US has had a shallower recession than the Euro-area, the UK or Japan and a more vigorous recovery. Together with the Greek fiscal crisis, this has seen a resurgent US dollar over the past five months. The US dollar was in a bear market from 2001 to 2008 and appears to have bottomed out since then supported by relatively stronger economic growth rates, valuation and the travails of the European Union (as shown in the $US/Euro chart below). Accordingly, we are biased towards long US dollar positions against the Euro and Japanese Yen in particular.

The growing confidence in the sustainability of the global economic recovery and a concomitant rally in risk assets have driven a further fall in volatility across all markets. This fall mostly reflects a massive drop in realised volatility. While implied volatility has not subsided to the lows seen during the credit boom and it is, in most cases, above recent levels of realised volatility, it is our assessment that it is low relative to the wide range of scenarios that may play out over 2010 and into 2011. In particular, the exit strategies from current extreme monetary and fiscal policy settings will require extremely delicate handling and some considerable luck. When viewed in this context, the fall in volatility appears to be overdone. We have a bias to long volatility positions and, with the ongoing fall in volatility, more positions are screening up to be implemented through long option positions, particularly in currency markets.

Outlook

To sum up, we still favour a modest recovery in the global economy this year as central case, led by very strong growth in the emerging economies. But there are a wide range of possible scenarios that may play out over the balance of 2010 and into 2011, particularly as the extraordinary global policy stimulus is unwound. The risks of policy mistakes are unusually high as governments and central banks attempt to find a way out of the extreme policy settings currently in place without triggering a renewed slump in the global economy.

In terms of positioning, we used the rally in equity markets in the second half of February to reduce our exposure as we are not inclined to chase equity markets at this point. We retain relative value trades preferring resources and technology stocks and long Japanese equities versus US equities.

Government bond markets (particularly in the US and the UK) are still viewed as vulnerable in coming months if the Fed and the Bank of England end quantitative easing (as appears likely). Indeed, it may be that such a sell-off will be required before the polity will get behind fiscal consolidation.

In currency markets, we continue to favour high yielding and/or commodity currencies and shorts in Euro and Japanese Yen. We have switched to a more constructive view of the US dollar particularly against the Euro and Yen.

In commodities, we favour gold against the Euro which has traded to new highs.