Which asset classes offer the best opportunities?
Twelve months ago it was hard to find anyone who was optimistic about any type of asset; yet investors who were brave enough to ignore the air of despondency were handsomely rewarded for virtually anything they bought.
The bounce in equity markets from the March 2009 trough was among the biggest equity recoveries ever; gold has been shining particularly brightly in a generally glittering market for industrial commodities; bonds have produced respectable returns and even commercial property is showing signs of life.
In 2010, investors will have to be more discriminating. While most of the experts we spoke to remain relatively optimistic, the consensus is that the easy gains are over; detailed analysis will now be needed to find the best opportunities.
The key to divining what 2010 holds for investors is the same as that which drove returns in 2009: quantitative easing, the polite way of describing the current policy of money printing by governments across the world.
The huge liquidity produced by that mountain of money - the UK alone pumped £200 billion into the market in 2009 - was in search of a profitable home and, with interest rates in Europe and the US at rock bottom, anything which looked as if it would produce a decent return was suddenly in demand.
Now, however, governments face a difficult balancing act: do they start on the path towards more normal fiscal policies by inching up rates and risk derailing the fragile improvement, or do they carry on with their lax fiscal policies, risking a build-up of inflation?
Current expectations are that low interest rates will last for most of 2010. "The risk is it will be pushed out beyond that," says Phil Collins, investment director at Newton Investment Management and manager of the Newton Phoenix Multi-Asset fund.
He is one of the more pessimistic among our experts: "The risks are increasing. The economic backdrop is not conducive to further price rises. If you compare any asset with cash, they look very good value. But it is possible that's because cash is mispriced."
Company profits in 2009 were generally ahead of expectations but, as Collins points out, that was almost all because of drastic cost cuts as managements prepared for economic Armageddon.
"You can only cut costs once, getting revenue growth is going to be tricky." That is the key reason most of our experts think equities in Asia and other emerging markets will be a better bet than UK equities.
Economic growth in Asia is likely to far exceed that of developed markets. David Jane, head of multi-asset and manager of M&G Investment's Cautious Multi-Asset fund, is one of the most bullish on our panel.
He thinks investors have been "climbing a precipice of terror" and suspects the key reason for the worry about whether the 2009 market recovery is sustainable, is that most fund managers missed it by not being fully invested.
"I can't help but be bullish," he says. "The UK economy is in poor shape, but much of the world is going well and so the UK outlook will not necessarily hold back asset prices."
He points out that, despite the sharp rally in equities, the UK stockmarket is still well below its 2008 peak, let alone the high point reached at the start of the decade. "The earnings outlook is not so bad. I am finding good companies with good growth opportunities, such as PZ Cussons, Colgate-Palmolive, as well as resources and capital goods stocks."
He thinks that the UK stockmarket could rise 10%, 15% or even 20%. "There is no reason for it not to be on a rising trend."
John Chatfeild-Roberts, head of independent funds at Jupiter Asset Management, agrees that equities look "OK for the moment". But he too worries about the outlook for earnings and warns that the current concern about deflation will turn to worries about inflation.
"Possibly not for a year or two but, when we do, it will increase bond yields and that could undermine equity markets," he says.
Government bonds have been supported by low interest rates and the massive repurchases under quantitative easing. While these conditions will continue, at least for the first few months of 2010, the risks of holding gilts will increase.
Andrew Milligan, head of global strategy at Standard Life Investments, says: "We do know that sometime in 2010, quantitative easing has to come to an end. It has been an unusual factor in the government bond market but the risks are building. You will need to be fleet of foot."
He also thinks there is still value in corporate bonds, although the rally in 2009 means that they should now be held for their traditional attribute of offering an attractive yield, rather than in the expectation of a repeat of the healthy capital gains enjoyed in 2009.
Robert Talbut, chief investment officer at Royal London Asset Management, thinks index-linked bonds are now looking "very expensive" while government bond yields "should trend up as quantitative easing comes to an end.
"Once we have seen that, government bonds will be a reasonable holding as a diversifying asset within the overall portfolio."
Jeremy Batstone-Carr, director of private client research and investment strategy at stockbroker Charles Stanley, says: "Corporate bonds have clearly had a very good run over 2009 and many private investors have opted for this 'half way house' as poor rates were offered elsewhere.
"I suspect the corporate bond market has seen the best of its performance, and if the UK economy does not recover or double dips, which is far from impossible, we could see problems here."
He adds: "I am unashamedly defensive in my risk orientation right now. I like yield, especially where it is underpinned by low financial gearing and reliable cash flow."
Property bounce back
Commercial property has had a dismal two years, plunging much faster and further than in previous recessions, although there has been a slight recovery in recent months.
Most of our asset allocation experts think the recovery should continue - although with the warning that a so-called double-dip recession could undermine the asset class.
Again, M&G's Jane is the most bullish. "There is huge value there and prices are now increasing."
He points out that 80% of the former Woolworths stores have already been let, indicating that there is demand from tenants, while investors are also coming back into the market to buy buildings.
Milligan agrees that values are 'appealing' but warns there is a risk that banks - big lenders to property companies - could decide to start selling. Yields on commercial property are currently as high as 8%.
"At the very least, it will provide a good income," says Milligan. "If you are holding property for three to five years, as you should be, you can expect a capital gain too."
Chatfeild-Roberts points out that prices have fallen so far that they are now back at 1980 levels, so property is "probably becoming more attractive" but he cautions that leases are not as cast iron as in the past and rents can fall.
The dollar and gold tango
The 2009 rally in commodities saw gold rise above $1,000 an ounce, oil bounce sharply from the lows at the start of the year, and the price of many industrial commodities, such as copper and aluminium, rise sharply.
Tom Elliot, strategist at JPMorgan Asset Management, says commodities remain a play on China and emerging markets. "It will not last forever. Eventually, the dollar will become oversold and strengthen, which will not be good for gold."
Talbut also worries about the relationship between the dollar and gold. "Gold could be picking up the fact that investors still harbour concerns about the long-term outlook for the economy. But it could also simply be picking up the loss of confidence in the dollar."
He thinks that industrial commodities have now "got ahead of themselves" but likes agricultural commodities, which were one of the few asset classes to perform poorly in 2009.
The weakness of the dollar was a major feature of 2009 and a bounce is expected during 2010, albeit possibly short-lived.
For Newton's Collins, the dollar is one of the "safe havens" for 2010. "It is the currency that is least correlated to risk assets. "When other things go down, you almost always see the dollar rising."
There was reluctance among our experts to make predictions about the precise level of returns they expect from asset classes in 2010 - reflecting the concern that policymakers will get it wrong on how and when to end quantitative easing.
"The biggest risk is that the government tightens prematurely," says Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management.
"The extent of public indebtedness and the burden on the taxpayer is rising up the political agenda. There is the danger that this could persuade government to do something prematurely."
That is one reason why most of our experts prefer overseas equities - emerging markets or US - to UK equities and, within the domestic market, they prefer the big overseas earners.
This article was originally published in Money Observer - Moneywise's sister publication - in January 2010
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Investors who borrow money they use for investment and use the securities they buy as collateral for the loan are said to be “gearing up” the portfolio (in the US, gearing is referred to as “leveraging”) and widely used by investment trusts. The greater the gearing as a proportion of the overall portfolio, the greater the potential for profit or loss. If markets rise in value, the investor can pay back the loan and retain the profit but if markets fall, the investor may not be able to cover the borrowing and interest costs, and will make a loss. Also used to describe the ratio of a company’s borrowing in relation to its market capitalisation and the gearing ratio measures the extent to which a company is funded by debt. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.