Equity Market Volatility will be rife in 2010 says SLI Head of Strategy
01 February 2010
Equity Market Volatility will be rife in 2010 says SLI Head of Strategy
Standard Life Investments’ head of strategy Andrew Milligan is a fan of corporate bonds and the US dollar for 2010.
Milligan predicts a year of volatility for equity markets and warns investors will need to think about putting ballast in their portfolios to counteract its effects. He also has strong views on when inflation and interest rates will pick up in the UK.
Is inflation a problem for 2010?
I do not see inflation being a problem in 2010, but we are certainly warning it may be a problem at some point in the future. I think, during the course of this year, inflation expectations may take a bit of a hit because we are going to be seeing headline inflation, the CPI and the RPI, pick up quite noticeably. We have had the first of the tax increases, the VAT rise, food- and energy-based effects should come in. Also, with oil at $80, perhaps higher with this cold weather, the CPI could be moving very quickly out of deflation back into inflation. But we do think core inflation, stripping out all the special factors, is going to be well under control this year and probably next as well. We have so much spare capacity. Unemployment is at 8% in this country, it is 10% and more in others, and wages are really under pressure, 1%-2% a year at most. Wages drive core service sector inflation and that drives the core CPI as a whole.
What happens to interest rates?
The first half of this year is bringing quantitative easing to an end, not just in the UK but in other economies as well. And the second half of the year will see some modest interest rate increases, partly because central banks will be wanting to say “look, the financial crisis is over, we are returning to some level of normality and therefore we are returning monetary policy slowly towards neutral levels”. But with the excess capacity out there, unemployment and inflation at low levels, it is still going to be a world of lower interest rates for longer. We do not see them returning to high levels until way into 2012 at the moment. So, the first interest rate increases in the autumn of this year will probably be led by the US, Europe and the UK lagging behind, and then slowly continuing during the course of next year. Dividend yield, corporate bond yields, credit yield are still very attractive, even when interest rates start to increase. Sustainable yield is the jargon, the phrase that we have been using. You buy yield where you can, and currently you have either got to buy long-dated cash, some sort of building society three- or five-year bond, or some other asset class, because even when cash rates start to go up it is not going to be quick and central banks are not going to be aggressive. They do not want to make the policy errors which Japan did in the 1990s.
Are corporate bonds a good buy at the moment?
We still think they are a good buy although, as with a number of other asset classes, there was considerable value say six, 12, nine months ago. It is not going to be quite as good value now and that value is probably depreciating during the course of this year. The good news for corporate bonds is firstly the yields and secondly spreads can come in. We are probably seeing the peak in default rates, companies going bankrupt and unable to pay their corporate bond obligations. That is probably going to happening this winter and spring. If the economic recovery in the Western world continues to gather pace, as we and everyone else expects, then investors in corporate bonds are going to be rewarded.
What about equity markets?
I would not say we are taking any strong bets one way or the other at the moment. That partly comes down to the fact in certain markets valuations do not look particularly attractive. Even where you are seeing some value, say for UK dividend yield, again those valuations are not as noticeable they were say nine months or so ago. Currency I think is quite an important feature to take into account. Very clearly we have seen the appreciation of the yen and the euro, the depreciation of sterling and the dollar during the course of the last six months. This is beginning to have a noticeable impact on export earnings in each of those countries. We are more of the view that some of those currencies could be changing direction as well, looking more towards some appreciation. We could see some strengthening of the dollar and therefore perhaps a bit of a relief rally for the exporters in Europe and Japan.
Are you confident corporate earnings will come through strongly this year?
Yes, and that is why we do like equities at this moment in time. And indeed, I would say one of our strong views at the moment is earnings could well surprise on the upside. At the moment the market is probably looking for about 20% earnings growth for most countries and for most sectors in the course of 2010. The good news is that looks achievable. I mean, I know economic growth is not going to be very strong in any of the economies, even in the US we are only talking of 3% growth. But companies have just constrained their costs so well and the unemployment figures are suggesting that into year-end they were still very wary about taking on new labour. So, we think with the combination of some increase in top-line sales and very strong cost controls, we could well be seeing earnings surprises. That is probably what will drive the equity market forwards. Then the market will get the shock of an interest rate increase, the end of QE, some fiscal tightening and it will go back to earnings again. That is why I think we are in the second phase of three steps forward, two steps back; the good news of earnings, the bad news of the policy tightening.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
This article was first published in Investment Week on Monday 1st February 2010.
