Investment comment

The improvement in economic conditions owes something to stock replenishment by businesses and much to the operations of governments and central banks that remained intent on steering their economies away from crisis. Asia, in particular, was reported to be recovering strongly as large-scale fiscal stimulus served to rejuvenate domestic demand. 'Protectionist' tendencies were disconcertingly evident at times, for example in the trade row between China and the U.S. over the latter's imposition of a new 35% duty on Chinese tire imports, but the policy-driven improvement in economic activity in all the major regions appeared to give investors grounds for optimism.

In credit markets, tensions continued to ease. By no means has bank lending returned to its pre-credit-crisis level, nor are loans being made yet over terms long enough to satisfy the demands of businesses. However, in the receding of the extreme 'spreads' on lending costs that characterized credit markets in 2008, and in the raising of fresh capital by banks, there was further evidence over the summer months that credit conditions had improved.

Investors received additional cheer from robust corporate earnings reports, particularly in the U.S., and they discerned a bright future for merger and acquisition activity, with France Telecom and Deutsche Telekom discussing a possible amalgamation of their respective Orange UK and T-Mobile businesses and Kraft seeking to buy Cadbury.

Against this backdrop, there were copious signs of greater confidence during the third quarter. Share prices rose strongly, the yield premia available on corporate bonds over their government equivalents continued to narrow, and Fabergé launched its first in-housedesigned collection of 'high-end' jewellery since being nationalized by the Bolsheviks in 1918. However, the strength of government bond prices and the ascent of the gold price above $1,000 an ounce in September cast doubt on the depth of improving confidence. Strong government bond and gold markets are usually incongruous with equity-market ebullience. They may be symptomatic of the seeping of central bank funds into financial markets or of the breadth of investors' quest for enrichment in a world in which short-term interest rates are very low. Alternatively, they may foretell a less favourable outcome for economic growth and/or inflation than that which stock market investors appear to assume.

In bond markets, government yields fell (and prices rose therefore) despite the gargantuan issuance programmes being undertaken in many of the largest nations. The JP Morgan Global Government Bond Index returned +5.9% in dollar terms (+3.9% over nine months). With credit spreads continuing to narrow, corporate markets continued to perform well.

All of the major equity markets appreciated during the third quarter, some of them dramatically so. The markets of the Pacific ex Japan region led the way with a collective dollar return of +27.4% (+64.5% over nine months), Continental Europe returned +23.0% (for a nine-month return of +32.4%), emerging markets posted an aggregate return of +21.0% to take their total return for the year to date to +64.9%, the UK returned +18.5% (+34.0% over nine months) and North America returned +15.9% (+22.1% over nine months). At another time, Japan's quarterly return of +6.6% might have looked respectable, but it placed it rather in the shade of its counterparts elsewhere and left its year-to-date return to the dollar investor languishing other major markets at +9.4%%.

Reports during the third quarter depicted improvement in the health of the U.S. economy, with the purging of business inventories for 40 consecutive months up to June seeming to have paved the way for a revival in activity over the summer. The widely watched Institute of Supply Management index rose during the quarter, with new orders data showing particular strength. There were tentative signs of recovery in the all-important housing market as well, with new house sales increasing and the Case-Shiller Index of house prices rising for three consecutive months up to July (the most recent month for which data is available). Elsewhere, buoyant car sales, aided by the government's 'cash-for-clunkers' program (which enabled consumers to receive up to $4,500 for their old car upon exchanging it for a new one) drove the strongest retail sales for three years. According to the Federal Reserve in September, recession in the U.S. economy was 'very likely over'.

Ben Bernanke was reappointed for a second term as chairman of the U.S. central bank in August, having presided over the U.S. economy's failure to grow in inflation-adjusted terms during his first four-year term. Mr. Bernanke emphasized throughout the third quarter that the economy faced a 'long haul' and that, given 'weak economic activity, substantial resource slack and subdued inflation', the Federal Reserve was committed to keeping interest rates 'exceptionally low' for an 'extended period'.

Meanwhile, the U.S. government's efforts to support the economy have appeared to be almost boundless. The budget deficit increased apparently at a rate of $4 million a minute during the summer and, remarkably, the U.S. government is forecast to borrow more during the next three years than it borrowed in total between 1780 and 1984. Such has been the Obama administration's munificence - 'cash for clunkers' was followed by a similar scheme aimed at encouraging consumers to buy energy-efficient appliances (and dubbed 'dollars for dishwashers') - that a 'cash for kitchen sinks' initiative might be an apt way to conclude the U.S. government's underwriting of consumer spending.

With U.S. consumers still highly indebted (the ratio of household debt to economic output remains only fractionally lower than the peak level at which it stood towards the end of 2007), the measures taken by policymakers may serve only to have anaesthetized the U.S.economy temporarily against the pain that may be inflicted ultimately by the ailing consumer. Fiscal and monetary policy stimulus is incapable of being deployed indefinitely, unemployment is expected to reach 10% of the workforce in 2010, wage growth is all but absent and home foreclosure activity is at a record high. Amid such challenges, the U.S. economy is likely to depend in large measure upon the growth in demand from overseas (and from more buoyant emerging nations in particular) to counteract the effects of its domestic consumers' woes.

Not since 1955, the year after food rationing ended in the UK (and when comparable records of economic activity began), has the UK economy shrunk in percentage terms as much as it did in the 12 months to the end of June 2009. The rationing of credit has been damaging to economic activity, but the determination of businesses to rebuild their balance sheets rather than to increase sales may have been a greater source of weakness. Household expenditure was also sluggish amid the further constraints of rising unemployment, falling house prices and the increasing propensity of consumers to save and to begin to repay their debts.

Reports suggested that the economy was likely to have returned to growth in the third quarter, with service sector activity rebounding and government spending continuing apace, but the longer-term outlook remains challenging (taking the form of a 'slow and protracted recovery' according to the Bank of England, and being 'grim' in the view of the British Chambers of Commerce). An increasingly large public-sector deficit will limit the scope of government spending to continue to bolster the economy; and subdued earnings growth, rising unemployment, a fragile banking sector and a rising household savings rate are likely to suppress the growth of consumer spending. One in ten stores in large towns and cities in the UK now lies empty (up from one in 25 in mid 2008) and a speedy rise in retail occupancy seems unlikely.

The Bank of England acknowledged in July that economic data was too muddied to draw firm conclusions about whether its 'quantitative easing' programme (under which it has bought government bonds and high-quality corporate debt to try to encourage bank lending and to lower overall borrowing costs) had been a success. In August, however, the Bank appeared tacitly to admit, in raising its outlay to £175 billion, that the £125 billion of purchases made up until then might have been inadequate. Remarkably, it later transpired that Mervyn King, Governor of the Bank, had been outvoted on his proposal to raise that amount to £200 billion and, in a further indication of his determination to restore order to credit markets, Governor King touted a proposal to pay negative interest rates on reserves held by commercial banks at the Bank of England. Whether such a move would indeed persuade banks to lend, or whether it would simply drive financial asset prices higher by inducing banks to diversify their funds out of cash, is uncertain.

Prime Minister Brown finally overcame his tendency for euphemism in September, in conceding that the consequence of his extravagance hitherto will be public spending cuts in the years ahead rather than simply 'tough choices' or the requirement to 'set priorities'. Holders of British government debt have been paid interest (and a reimbursement of their capital upon maturity) without interruption since the Stop of the Exchequer in 1672 and, while there is little danger of a break in that record, there can be no mistaking the policy implications of preserving it. Whichever party is 'successful' in taking office following the general election that must be called by June 2010, it is almost inevitable that fiscal policy will hinder, rather than enhance, economic growth in the coming years.

In Europe, news of an unexpected bounce in the French and German economies in the second quarter fuelled expectations that the worst of the economic downturn was over in the eurozone. During the summer months, data continued generally to point to improving economic conditions, and the strength of the euro and the narrowing in the range of government bond yields across Europe also suggested greater stability in the region.

Short-term factors appear, however, to be exaggerating the strength of the European economies. Inventory rebuilding and emergency fiscal stimulus measures were likely always to flatter Europe's economic might, and it remains to be seen whether the region will enjoy a sustained recovery as the influence of those factors fades. The growth in export activity, attributable in large part to the faster-thanexpected recovery in Asia is encouraging, but Europe, like the rest of the developed world, is likely to undergo a period of frugality that should suppress overall activity in the coming years. In August, youths pelted a town hall in Pinto, south of Madrid, with eggs and tomatoes in protest against budget reductions that forced fiesta organizers to cancel some bullfights. Unpopular acts of austerity seem increasingly likely as governments face the consequences of their lavish spending to date.

Such has been the weight of responsibility on monetary policymakers that the European Central Bank convened an August meeting of its governing council for the third summer out of four; traditionally no such meeting occurred during the month. Ominously, the ECB has already announced that it will hold similar meetings in Frankfurt in 2010 and 2011, signifying perhaps that Europe's central bankers do not expect an imminent return to benign economic times. During the third quarter, the ECB held rates at 1% and set an optimistic tone in its outlook for Europe's economies, but its policymakers stressed (in contrast with their traditionally grudging rhetoric) that they were in no rush to jeopardize Europe's fragile economic recovery by tightening policy.

In similar fashion to its U.S. and European counterparts, the Japanese economy has drawn strength in recent months from public investment and from fiscally inspired consumer spending. Most measures, however, have pointed to the still-feeble nature of private sector demand, and consumer price deflation has deepened (despite near-zero interest rates), prompting the Financial Times to ask whether Japan had really ever left its recession.

The election of the Democratic Party of Japan brings fresh hope that the country will discover the political will to mend its economic troubles. The DPJ campaigned on promises to reduce taxes on small businesses, to raise spending on childcare and healthcare and to reduce the influence of Japan's powerful bureaucrats. The 'change' agenda has become hackneyed through its promulgation by political parties around the world in recent times, but in Japan the requirement for change is genuine.

Whether the DPJ can deliver the kind of change that will put the Japanese economy on a sounder footing is debatable; its appointment of a number of old Liberal Democratic Party members is not the most encouraging augury of the new regime. The achievement of entrenched economic growth remains stymied by the deep-rooted aversion of consumers either to borrow or to spend. The global financial crisis that has unfolded over the last two years is only likely to have hardened that aversion and, with wages falling at their fastest rate in the summer for 20 years and unemployment rising to its highest level since the Second World War, the DPJ has much work to do in cajoling Japanese consumers to change their habits. In the near term it seems more likely that any economic improvement will derive from rebounding industrial output, improving demand for Japanese exports (subject to the extent of the yen's further appreciation) and the contribution of continuing government spending initiatives.

The health of the economies of the Asia-Pacific region grew significantly ruder during the summer. Domestic demand rebounded strongly owing to the support of the largest fiscal stimulus (as a percentage of GDP) of any major region in the world; given their moderate indebtedness, Asian households and firms proved to be suggestible to spending government handouts. Following the earlier running down of inventories, orders swelled and factory production grew accordingly; and, amid improvement in global trade financing terms, export activity increased as well.

In China, the sum of the parts of economic activity seemed, like the England one-day cricket team in its post-Ashes series against the Australians, to be less valuable than the parts themselves; the first-half statistics provided by provincial authorities painted a brighter picture than the amalgamated data declared subsequently by the central government. Nonetheless (and despite the weakening of output in July following a decree that state-controlled banks rein in their excessive lending), the Chinese economy appeared to maintain a substantial rate of growth.

Asian policymakers have fretted increasingly about the threat of asset 'bubbles' in their economies, not least as a result of ultra-low interest rates in the U.S., to which many Asian economies are effectively tied via their dollar-related currency pegs. As well as China's decision to staunch the flow of funds being lent by its banks, politicians in a number of other countries (including South Korea, India and Vietnam) took steps to address excessive credit growth. Authorities may be required to be ambidextrous in their policy maneuvers. Tame consumer inflation should afford them some breathing space to maintain loose policy. However, rapid asset-price rises may test their forbearance of such policy, and they may regard external demand as remaining too weak to permit the higher exchange rates from which their domestic economies would benefit.

In Latin America, economic activity appeared generally to be improving during the third quarter, but the major economies in the region are likely to contract nonetheless over 2009 as a whole amid sharp declines in industrial production and exports. Differences between those economies are marked, with Brazil remaining the strongest performer. Aggressive policies have afforded many Brazilians access to credit for the first time, the government has instituted tax cuts, and, with inflation having fallen from almost 20% to less than 5% over the last six years, the central bank has cut interest rates sharply. Against that backdrop, growing consumption has been highly beneficial to the resilience of the Brazilian economy as a whole.

Government bond investors might reasonably have been expected to mutiny in the face of escalating sovereign debt issuance during the summer, but instead they appeared to see sufficient bounty in government bonds to drive yields lower (and prices up). The yield on the 'benchmark' 10-year U.S. Treasury bond, for example, fell from almost 4% in June to about 3.3% at the end of September. Changes in exchange rates, however, made significant contributions to overall returns, with sterling weakness enhancing returns to the UK-based investor.

For the time being, the rapid issuance of debt by high-rolling governments has not appeared to trouble government bond investors, but the 'quantitative easing' programmes of some of the world's principal central banks may have served to mask any incipient concern. Those programmes have had an unquantifiable effect on bond yields, but it is difficult to conceive that monetary policymakers' engagement in bond markets has not played some part in the decline in yields; in the UK, the Monetary Policy Committee's liquidity-driven purchases had led to the Bank of England's owning about one-fifth of all gilts by the time the MPC expanded its purchase program in August.

Government bond prices may also have been supported by the lack of appeal in ultra-low short-term interest rates (particularly among banks replete with central bank funds and keen to rebuild their balance sheets) and by apprehension about the sustainability of economic recovery. In the near term, those sources of support are likely to remain in place, but sovereign markets may weaken if governments, via their vast issuance programmes, exceed investors' enthusiasm to hold their bonds (or central banks' policy-driven scope to buy them).

Despite the increasing rates of default by companies on their debt, corporate bond investors enjoyed another quarter of prosperity, with yield premiums on both investment-grade and high-yield bonds over their government-issued equivalents continuing to narrow during the summer. A less malignant corporate backdrop than that which investors had feared, together with the allure of relatively high yields (compared with low cash interest rates), has allowed corporate bond prices to rise strongly. There remain attractive opportunities to buy corporate debt. However, investors in higher-quality paper will have to be mindful of events in government bond markets (with which their fate is likely, following falls in corporate bond yields, to be more closely aligned) and, given the ascent of prices to date, a selective approach is likely to be increasingly important.

U.S. equity market investors enjoyed another quarter of strong share-price gains during the summer. With money-market funds yielding an average of 0.1% after fees this year, investors have withdrawn an estimated $332 billion from such funds during 2009 (equivalent to 10% of the total held); and, amid an improving economic backdrop and strong corporate earnings reports, investors deployed many of those funds in U.S. stocks during the third quarter.

Three quarters of companies in the S&P 500 Index exceeded market forecasts for their second-quarter earnings (the highest ratio in 15 years), with the improvement being attributable to the fattening of profit margins at a time when sales actually fell. U.S. corporations have taken advantage of flexible labor laws to cut costs and improve margins but, with their frugality already evident and with uncertain economic conditions making it unlikely that they will be able to grow sales significantly, they may struggle to continue to surpass (already lofty) expectations of their profitability in 2010.

The rally in U.S. share prices this year has not been universal; stocks in sectors that were weak in 2008 (generally those with lower-thanaverage credit ratings), and particularly those deemed previously to be closest to bankruptcy, have recovered most strongly this year.

With earnings-related valuations of the U.S. stock market as a whole being less attractive than previously, a bias towards large, higherquality companies, whose valuations generally are less demanding than smaller, lower-quality counterparts, seems appropriate. The financial sector has benefited greatly from the measures of central banks to support it, but those measures will not last indefinitely and, with the outlook for commercial banks' profitability uncertain, a highly cautious approach to the banking sector remains warranted.

In the UK, a growing conviction that the worst of the economic downturn was over, together with improving corporate earnings news, brought about the strongest quarterly rise in the FTSE 100 Index of leading UK companies since its inception in 1984. The quantitative easing programmes of the major central banks, particularly the Bank of England, and the lack of appeal in lowinterest- earning cash are likely also to have been instrumental in equity-market strength.

The overall health of the UK's stock market since its nadir in March has masked a challenging picture for income-orientated investors. In the first half of 2009, companies listed on London's main market cut their dividends by 9% in aggregate and, in the second half of the year, a further (less severe) reduction is likely. In addition, during the first six months of the year, the value of the capital raised by companies exceeded the value of dividends paid for the first time in many years; in fact UK companies raised more capital during the six months to June than in the five years between 2003 and 2007 combined. The paucity of credit available and the desire of companies to rebuild their balance sheets seem to explain this development. As credit conditions remain tight and companies remain frugal, a stock-specific approach will be imperative to manage the risks associated with dividend cuts.

European markets appreciated by almost 30% during the third quarter in sterling terms, buoyed seemingly by the leaching of economically motivated central-bank liquidity into asset markets and by improving economic and corporate news (albeit that Europe's recuperation has tended to be less emphatic than that witnessed elsewhere in the world). With Europe's monetary policymakers explicit about their intention to maintain 'loose' policy for the time being, and with interest rates offering little solace to yield-hungry investors, share prices may strengthen further. The long-term challenges that exist in Europe in the aftermath of the global credit crisis are likely to impinge on corporate prospects for many years, but the region's globally diversified, 'blue chip' companies may benefit nonetheless in the period ahead from economic improvement elsewhere in the world.

Not since 1988 has the Japanese stock market risen for 11 consecutive days, but it did so during July this year, before failing thereafter to participate fully in the worldwide share-price rally. Improving investor confidence has echoed growing business confidence, notwithstanding Japanese companies' plans to scale bank their capital expenditure this year. Merger and acquisition activity and other corporate reorganizations have continued apace (in, for example, the banking, brewing and technology sectors) and Japanese investors have been buying their domestic equities on a net basis for the first time since 1990.

Japan's economic challenges remain considerable, but the election of the Democratic Party of Japan brings renewed hope at least that some of the economy's ills may be cured; the DPJ's inclination to transfer income directly to households via social support seems a more durable way to boost demand than the previous ruling party's policy of building 'bridges to nowhere'. Japanese companies' exposure to trade with the fast-recovering Asian region should also be beneficial, as should the previously parsimonious habits of Japanese households, whose stable financial standing contrasts sharply with that of their counterparts in many of the Western economies. With the vast proportion of Japan's estimated $14,000 billion of financial assets languishing in low-interest-paying bank deposits and with Japanese equities trading at much lower 'book-value' related levels than, for example, their U.S. equivalents, there is scope for stocks to perform well should confidence about Japan's economic outlook improve.

The stock markets of the Asia-Pacific and Latin-American regions took their respective aggregate returns for the year to just under 50% during the third quarter with another period of strong gains. The liquidity created by the developed world's central banks appears to have flowed into Asian and Latin-American financial markets in large measure. Investors, as well as policymakers, should be mindful that such liquidity may spawn the development of asset price 'bubbles', but the strong fundamental outlook for companies in parts of Asia and Latin America should support equity investment in both regions in the long term.

Unlike in the U.S. and Europe, where the indebtedness of companies and consumers and the defectiveness of banking systems have blunted the tools of monetary policymaking, stimulus in Asia and Latin America should be highly effective in supporting corporate earnings growth via higher domestic spending. With currencies in both parts of the world likely to appreciate, and with governmental influence in financial markets there diminishing (in contrast with more developed markets), judicious long-term investment in the regions' equity markets should be rewarding.

It would have been alarming had the intense fiscal and monetary stimulus employed this year not served at least to restore some order to global economies and financial markets. In the near term, conditions have indeed stabilized but, while some improvement in economic activity has been evident, it is in asset markets that the effects of authorities' stimulative efforts have been most immediately visible. The 'backflow' of liquidity into financial markets (that was intended by authorities principally to improve the supply of credit in the 'real' economy) appears to have been significant and may well explain why the prices of incongruent asset classes have risen in unison.

Economic growth could remain strong in the coming months as firms continue to replenish their stocks and as the sluice gates of government and central-bank liquidity remain resolutely open. However, inventory levels will eventually be restored sufficiently to meet demand, and authorities, whatever the strength of their commitment to support economic and financial-market conditions, ultimately will reach the limits of their largesse. In the 'developing' economies of Asia and Latin America, consumers and companies should be key sources of rising output; but in the developed world it is unlikely that private-sector demand will atone more than modestly for the impact of fading public-sector spending.

Low interest rates and plentiful liquidity have given investors a powerful motive for pursuing riskier activity. However, the consequences of 'easy money' are uncertain, and there is danger, in places, that asset prices may reflect disproportionately the effects of loose monetary conditions, inadequately the risks associated with the eventual tightening of those conditions, and insufficiently the fundamental difficulties that companies still face.

The synchronized ascent of bond, gold and equity prices will not last indefinitely and, eventually, some form of adjustment in one or more of those asset classes is probable. Stock markets may continue to find support overall but, following the significant progress of those markets over the last six months, a cautious approach to equity investment seems appropriate. Nonetheless, with the share prices of many large, higher-quality companies having risen by much less than markets as a whole, a selective and tempered approach should continue to identify attractive investment opportunities.

"He sows hurry and reaps indigestion."

Robert Louis Stevenson, 'Virginibus Puerisque' (1881)