Principal Investment Management

Update on world markets - 30 September 2011

29/09/11

Economic growth prospects have continued to weaken, and markets now fear the developed economies are heading back into recession. In addition, there is considerable anxiety around whether the eurozone crisis will result in a new credit crunch. We feel that neither a recession nor a credit crunch are a forgone conclusion albeit the probabilities of both have increased.

Markets

Bond yields in Spain, Italy and Ireland have fallen back a little from their peaks, but they remain too high for comfort. Greek default is inevitable, but its timing and exact form remain uncertain. The politicians are clearly trying to delay it, to allow a rescue package to be delivered for the banking system. The rotation between hope and fear, to which this gives rise, is likely to continue to cause volatility.

Meanwhile, the agreement over the US budget has removed the issue of potential US default from the headlines. Calmer consideration of the downgrading of the US credit rating soon brought a realisation that this is largely a technical issue. The risk of US default in the short term remains very low and investors have noted that previous instances of the loss of a triple-A rating have not necessarily led to rising bonds yields. Indeed, US Treasury yields have fallen to historic lows in recent weeks – hardly a sign of a crisis in investors’ confidence. Bonds now seem to offer value only, essentially, as an insurance policy against a repeat of the dislocation in the credit markets that occurred in 2008/9. The prospect of a rise in interest rates seems to have been deferred almost indefinitely.

Risk is obviously high, and conditions for a sustained recovery in equities will not exist until investors see the potential for developed economies to strengthen and when there is a resolution to the eurozone’s crisis. We think that it will take many years to bring sovereign debt levels down to a point where they cease to worry investors. While these uncertainties remain, markets will continue to have periods of volatility.

Policy makers in Europe have been creative in trying to resolve the symptoms of their problems, without resolving the root cause – the high levels of debt in some countries. If a consequence of Greek default is that the Spanish or Italian governments find that international markets will no longer buy their bonds, awkward decisions that have been persistently put off, would have to be made. In recognition of this, we have reduced our exposure to European equities.

However, markets are already pricing in much of the uncertainty and seem to be assuming a continuing paralysis in policy. We also feel that in their alarm about sovereign debt, investors have been overlooking the extent of the improvement in corporate balance sheets since the crisis of 2008/9. Thus we expect more companies to buy back their own shares, and the bid activity that has gently gathered momentum in recent weeks will continue, as long as credit markets remain fluid. It certainly seems to us that many stocks offer yields which compare favourably to most other assets.

Conclusion

Our central expectation remains that we will continue to “muddle through”. When Greek default comes it will cause a moment of tension; but we do not think that the will to defend the euro can be underestimated, and Greek default by itself should not undermine the world’s banking system. Hence, while we remain conscious of risk, we don’t expect it’s the last time that the concerns, which caused so much volatility over the last two months, will hit the headlines. That being said, we continue to think that shares do have some attractions relative to other assets.

“Safe” assets such as gilts and gold now look as expensive as at any time in recent history. We think that to buy more of them at these prices is, implicitly, to assume that a full-blown crisis is about to take hold again. So, outside Continental Europe at least, we have been casting our eyes, on a highly selective basis, on fund managers who have shown an ability to understand and prosper in this climate, and on shares that look attractive to us. Also, businesses that are relatively resistant to recession, have strong balance sheets, generate cash and offer attractive dividend yields will have strong appeal.

Important information

Investing involves risk. The value of investments, and the income from them, may fall as well as rise and is not guaranteed. Investors may not get back the original amount invested.

The views expressed above are based on information which we believe to be reliable, but are not guaranteed as to accuracy or completeness by Principal, and any expressions of opinion are subject to change without notice. This article is for information purposes and should not be treated as advice to buy or sell any particular investment.

Stephen Jones, Chief Investment Officer

Authorised and regulated by the Financial Services Authority. Registered in England and Wales No.2041819. Registered office: 16 South Park, Sevenoaks, Kent, TN13 1AN. Part of the Sanlam Group. Border Asset Management is a trading name of Principal Investment Management Ltd.