strategies-for-sailing-through-the-storm

Strategies for sailing through the storm

While volatility remains high, investors will need to distinguish between purely speculative trades and allocations backed by fundamental value.
Tightening credit conditions and the prospect of a further deepening of the housing recession in the US threaten economic growth not only in the US but also globally. The FOMCÆs (Federal Open Market Committee) decision to lower the Federal Funds target rate from 5.25% to 4.75% in September helped reduce market uncertainty and created a positive environment for global equities. However, mixed economic news and a continuing recession in the US housing market are likely to ensure that market volatility remains elevated. As a result, investors will, increasingly, need to distinguish between purely speculative trades, and allocations backed by fundamental value.

The FOMCÆs decision to lower the target rate acknowledged the growing downside risk to growth stemming from deteriorating financial market conditions and uncertainty in the housing market. Financial markets welcomed the move with equity markets performing well, and spreads in credit derivative markets narrowing, suggesting that tensions in corporate bond markets may start to recede. However, while the VIX index of implied volatility for the S&P 500 also took a step back from high levels, volatility is likely to stay above-average in light of the continued uncertainty surrounding the US housing market.

We recently advised clients to reduce their bias towards equities, after markets had recovered losses incurred in August. Nevertheless, while the weighting of equities relative to bonds has been reduced, we believe global equity markets continue to warrant preferential treatment. However, the way to play equities in terms of what regions and what styles will become even more decisive going forward.

Focus still on US housing

Given the impact of developments in the US housing market on global credit, it comes as no surprise that investors continue to monitor the market closely. The crucial question is whether the negative news that is likely to emanate from the market over the coming quarters will be offset by other factors, including the FedÆs pre-emptive move. There is no question that market volatility will continue. What is less easy to predict are the factors which will determine the fate of risky assets going forward?

First, given the retreat in US consumer spending, investment spending together with demand from abroad both have the potential to be major pillars for US economic growth and help avoid a plunge into recession. Globally as well as in the US, the corporate sector is healthy with sound balance sheets and strong cashflows.

At the same time, high capacity utilisation in the US suggests the need for companies to engage in capital spending, which should also be supported by low interest rates. While, in terms of foreign demand, recent export and import data suggest that the US current account has arrived at an inflection point, as export growth has started to outstrip that of imports. Of course, a weak US dollar will also play an important role in the international competitiveness of the US.

Second, the scope for central banks to ease monetary conditions will be crucial and will rest, to a large degree, on the outlook for inflation. Should inflation indicators remain muted, then investors should be rewarded for betting on central banks to keep the global economy running. Recent rises in food and energy-related prices have stimulated discussion on the longer term outlook on inflation but it is important to note that core inflation in most countries û excluding volatile food and energy prices û is still low. Any moderation in global growth should reduce future inflation risks.

Still, there is not much room for complacency, and we do not believe that investors should take further strong supportive Fed action as a given. Further easing is likely only in as much as it is a counterbalance to increased growth risks, and whether the net balance for risky assets will be positive is, at this juncture, uncertain.

Third, and most importantly, the strength of the global economy ex-US will be the key differentiating factor in this cycle. Indicative of the importance of ex-US growth has been the resilience of Asian equities during the recent market turmoil. It is true that Asian equities have experienced a roller coaster ride, but the upward trend was never broken as in other regions, as investors' seem to take increasingly heart in the Asian growth story. Besides Asia, Europe also has started to show more domesticbased growth dynamics with labour markets improving. All of this provides hope that the US will receive support from the economic strength of other regions.

















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