Economic recovery in the West is good news for equities 
(10/05/2010)
Baring Asset Management (Barings) has upgraded its position on equities from neutral to positive. The upgrade follows the publication of Barings’ latest research, which suggests there is a strong enough body of evidence showing the economic recovery in the West is well underway, albeit at a more subdued pace compared to past cycles. However, longer term, it remains uncertain about how strong the US and European recoveries might be.
Barings’ cautiously positive outlook follows concerns that the scale and power of the rebound in the real economy might be very weak and prone to relapse on the withdrawal of government support. Having closely monitored three key areas – employment support, the US housing market and the auto sector – it believes there are reasons to be optimistic.
Percival Stanion, Head of Asset Allocation at Barings explains: “We downgraded equities to neutral in August last year because the sheer power of the rally in risk assets required the overbought position to be removed either by a setback in market prices or by the passage of time. We finally got a correction in January and February but since then markets have been moving inexorably upwards.
“Employment seems to have turned the corner with the latest non farm payroll showing solid job creation. Although the consumer is still weak due to balance sheet issues, retail sales are rising and car sales in the US appear to be rebounding towards a reasonable rate of about 12 million units a year - well up on 2009 and holding steady without government hand outs.
“The weak spot in the US remains the house market, which has slumped back over the winter months and shows little sign of recovery despite low servicing rates on mortgages. Still, its condition doesn’t seem bad enough to drag the whole economy back down again.
“Within equities our sector policy has recently formed a bar-belled strategy, with cyclical sectors hedged with some defensive positions. We now feel the recovery is sufficient for us to nail our colours to the mast. As a result we have upgraded Technology as it is a sector that will benefit most from capital expenditure, while balance sheets are strong enough to withstand policy tightening. We have also capitulated on Consumer Durables and upgraded them even after the strong rally. Capital discipline in the sector is very strong and capacity has been shrunk in many sub sectors. Even weak consumer growth will see continued margin surprise here. Consumer Staples and Telecoms, both traditional defensive sectors, have been downgraded.”
Over the longer term, Barings remains uncertain about the strength of the US and European recoveries. It believes that in the US private sector, capital investment is likely to be very slow, while the public sector is likely to get squeezed back as state and Federal Budget issues come to the fore.
Stanion continues: “This doesn’t paint a robust picture for 2011. While growth is likely to continue, it may be below the recent trend of 2.9%. This is not a disaster but corporate profit margin expectations next year might be vulnerable. Similar arguments apply in Europe and the UK where private sector recoveries will be moderated by fiscal tightening, especially in Southern Europe.”
Looking at global GDP growth forecasts, Barings concurs with the International Monetary Fund’s (IMF) prediction of 3.9% for 2010, which would be stronger than the average for the 1990s, a relatively strong period in global activity. However, Barings considers the IMF’s global GDP prediction of 4.3% for 2011 to be overly optimistic.
Moving on to Asia, Barings believes most of the large Asian economies have to tighten further. Although China has reduced its loan growth, the firm believes it will need to hold a tough line for at least twelve months. In India, Barings believes that more must be done to reduce its short-term interest rates given the 15% rise in agricultural prices while it says that Australia is well on the way to normalising interest rates at around 5.5%.
Stanion concludes: “While there is still plenty to worry about over the next few months and markets may be a little extended on a very short-term view, the direction of advance still seems for markets to grind higher. Equity risk premiums are back to reasonable and even slightly attractive levels in the UK and US and corporate bond spreads seem likely to narrow further.”
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