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Economic recovery remains on track, says Skandia

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The recovery in equity markets that began in March should continue and credit spreads will narrow further, according to Skandia Investment Group.

The recovery in equity markets that began in March should continue and credit spreads will narrow further, according to Skandia Investment Group.

Chief investment officer James Millard says most data in June confirmed that the recovery was broadening around the world. Business sentiment indicators rose, with the leading components suggesting positive industrial production and GDP in the second half of the year. 

‘We remain overweight equity markets. Equities are cheap against both bonds and cash and they should be well supported in the months ahead. We continue to prefer Asian equities over non-UK/European equities because while Asia is already out of recession, most European countries are not. This is in part the result of a weak monetary and fiscal policy response to the crisis. We also remain overweight corporate bonds, both high yield and investment grade, as we expect spreads to narrow further from their current wide levels,’ says Millard.

Part of the reason for SIG’s optimism is that industrial production has fallen so far so fast that it needs to increase to stop a sharper than necessary fall in inventories. For example, Millard says the collapse in auto production in late 2008 and 2009 has succeeded in bringing down inventories, even though sales have also fallen rapidly. 

‘With auto sales stabilising and likely to be boosted by the recent ‘cash for clunkers’ legislation, auto production will probably need to rise sharply as auto inventories have fallen to low levels.’ 

Millard says that while the outlook for the second half of the year has improved, much of the global economy remained in recession in Q2 2009. In June, US payroll growth remained negative and the unemployment rate rose further. On unemployment he says that it was likely to continue to rise this year with the consensus expecting a peak at over ten per cent in the US. 

While SIG sees recovery it also believes that the global economy remains fragile with ongoing weakness in the banking sector (particularly in emerging Europe) and where budget deficits remain at extreme levels. In addition, despite low short term interest rates recent longer term bond yield increases have pushed mortgage rates higher in the US, threatening to undermine a US housing recovery. 

Millard anticipates that inflation will remain low: ‘High unemployment and low capacity utilisation is likely to put downward pressure on prices for some time to come. Core inflation is already close to historic lows in the developed world and it could fall further in the quarters ahead. This should allow central banks to keep interest rates at very low levels for a prolonged period even if the economy recovers as we expect and commodity prices rise. Tighter fiscal policy from 2010 onwards should take some of the pressure away from the need for higher rates.’

SIG remains overweight credit markets, especially investment grade and high yield. Although spreads have narrowed significantly since the spring, they remain at exceptionally wide levels. Corporate profits are set to pick up as the economy moves out of recession. This should help credit spreads as will the sharp increase in new equity issuance. While it is unlikely that credit spreads will return to the levels seen in 2006 and early 2007, they could narrow substantially over the next few quarters. 

Within equity markets, SIG continues to prefer Asia Pacific ex Japan, at the expense of Continental Europe.  The eurozone continues to perform poorly, although it should benefit from a pick-up in world trade in the second half of the year. Meanwhile, emerging Europe continues to suffer with the fixed exchange rate pegs in the Baltic hampering the region’s attempts to boost growth. 

In terms of investment style SIG favours small and mid capitalisation stocks relative to large caps as the global economy recovers. It also prefers value when compared to growth and expects financials to perform well.  In the currency markets, the British Pound was the strongest performer among the G10 currencies. The GBP’s strength was largely caused by signs that the UK will be one of the first major economies to emerge from recession. With core inflation yet to fall as much as in many other developing countries, this could put pressure on the Bank of England to raise interest rates late this year or early next. SIG thinks that rates in the UK will stay at 0.5 per cent well into next year. 

Millard adds: ‘Consensus is coming round to our way of thinking with the majority of fund managers now overweight equities, albeit by a small margin, for the first time in well over a year, according to ML Global Survey 17th June.

‘An ongoing improvement in economic and earnings growth expectations are the main reasons behind this improvement in sentiment and positioning. In terms of regional allocation, we are in line with consensus preferring Asia ex Japan, with continental Europe the least favoured. In terms of sector allocation, we are now more optimistic on the financial sector, while the consensus remains underweight. We and consensus continue to favour the usual cyclical stocks, such as materials and IT. In terms of currency, we are broadly in line with the consensus. The euro is now seen as the most overvalued currency. The US Dollar outlook is broadly seen as fairly valued, with emerging market currencies undervalued.’

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