QUARTERLYINVESTMENTOUTLOOK

“We live in an eraof low predictability:anything couldhappen.”Tony Blair interviewed byAndrew

Marr on BBC2,1st September 2010

Financial markets have continued their erratic course through 2010 and it seems thatone task in writing a Quarterly Investment Outlook is to temper the prevailing moodof optimism or pessimism. Sentiment in markets has been swinging from irrationaloptimism to excessive pessimism and seldom pausing to take a rationale view offuture prospects. Over the past three months, most equity markets have bouncedback from losses experienced in the previous quarter and in aggregate the level ofglobal equity markets is close to where it started the year.As there has been growingpessimism about the outlook for the world economy, the recovery in share prices hasnot been at the expense of bonds. Indeed,worries about deflation have helped causea sharp drop in yields in core government bond markets. Reflecting these moves,greed has triumphed over fear for the time being at least. But several commentatorshave drawn attention to the inconsistency of recent movements in financial markets.Disappointing economic news, and fears of deflation which have driven bond priceshigher, are not conditions that are compatible with healthy equity markets. In the lightof this, having a clear economic outlook would seem to be an ever more importantcharacteristic of a successful investment strategy, but unfortunately as the formerPrime Minister Tony Blair remarked recently “We live in an era of low predictability:anything could happen.”

Inflation or deflation – which is it to be?

Three months ago, plunging equity markets permitted a comparatively optimistic approach as we viewed the sharp fall in share priceson global markets between April and the end of June as a chance to invest at attractive values. However, while we had anticipateda recovery in equity markets, we had not foreseen the sharp rally in government bond prices.This rally has taken yields back downto 2.8% in the case of UK 10 year gilts, levels last seen in March 2009, when many markets were gripped by the fear of a deflationaryglobal economic slump. Increasing demand for “low risk” investments from pension funds, banks and investors looking for homesfor cash, have undoubtedly played a part in the bond rally, although doubts about the strength of the global economic recoveryand the possibility of deflation have probably been the most important issues affecting bond yields. Nevertheless, it is noticeablethat this rally has coincided with other changes in asset prices, such as the rise in the gold price, which would suggest other investorsare worrying more about high inflation than deflation.While such moves may seem incongruous, this dichotomy is confirmed byThe Bank of England’s recent Inflation Report. Using data derived from the pricing of financial instruments, this report showedhow, over the past two years there has been both an increase in the chances of deflation and serious inflation occurring in five yearstime. In other words, while the chances of a benign environment of low inflation close to the Bank of England’s 2% target hasdeclined, there is increasing uncertainty about whether the most serious threat to the Bank missing its target is presented by highinflation or deflation. It seems that the era of comparative price stability is like a dying tree perilously placed between two houses:the chances of it flattening the houses is increasing as it dies, but no one knows yet which way it will fall. However, just as it mattersfor the owners of the two houses which way the tree falls, so it matters for the owners of different types of financial asset whetherthe economy ends up with a serious bout of inflation or deflation.

We believe the inflation versus deflation debate will continue to be highly influential in the performance of financial markets overthe next year. However, we think it is unnecessary to take a firm view as to how it will be settled, because the most likely surprisewill be how long the debate continues until it becomes clear whether inflation or deflation is more likely. Prior to the onset of theCredit Crisis the Governor of The Bank of England, Mervyn King, referred to the UK economy as having enjoyed a NICE decadeof Non-Inflationary Controlled Expansion. Echoing this phrase, the Citibank economist Michael Saunders warned early last year ofa sustained VILE period of Volatile Inflation with Low Expansion for the economy.We think Saunders’ observation is accurate, andprovides a summary of a sensible economic framework in which to invest. Serious headwinds, such as the impairment of thebanking system, paying down debt and negative demographics in developed economies, will all undermine economic growth for along time to come. However, subdued growth need not imply that deflation takes hold. Nor does the quest to boost economicgrowth through quantitative easing imply that runaway inflation is inevitable.This is because so far there is very little evidence thatthe electronic version of printing money has led to the increasing money supply required to imply that high inflation is around the

corner.Thus, while it is easy to sympathise with the views of several investors of high repute who are arguing that high inflation isthe inevitable consequence of excessively loose monetary policies, we think it is too early to invest on the basis of such a view.

Aside from the debate about the outlook for inflation we continue to keep a wary eye on other risks confronting markets, suchas the instability of the Eurozone.While investors currently seem far less concerned about problems in the Eurozone than theywere in the Spring, it would appear that this more relaxed attitude is not entirely justified. Indeed, the gap between the yield offeredby the bonds of the Euro’s members with the weakest economies, notably Greece, Ireland and Portugal, and those of its strongest,Germany, have widened sharply, suggesting there is a significant danger that global financial markets will face renewed turbulencebefore a lasting solution to the Eurozone’s problems is found.

Where we are investing

A notable consequence of the severe headwinds to growth in western economies has been the need for central banks to keepinterest rates at record low levels.This has meant cash provides a desultory level of income and, following the recent steep fall inthe level of government bond yields in core markets, the most commonly accepted “risk-free” rates of return are now atunacceptable levels for all but the most un-ambitious and timid of investors.This dynamic creates obvious dangers, in terms of therisk-taking impetus it encourages in markets. It does this by causing a general inflation of asset prices as investors seek homes forcash, forcing the valuations of alternative assets to levels that are difficult to justify.While we are finding some value in fixed interestmarkets, we do have concerns about signs that some investors are adopting an overly optimistic view of the future performanceof the asset class and forcing prices to excessive levels. The behaviour of the issuers of bonds suggests they believe as much.Interestingly, some companies such as Microsoft, are now issuing bonds to fund buybacks of their shares, while recently theenthusiasm to lock in long term cheap financing has culminated in a few companies, including the Dutch Bank Rabobank, issuing100 year bonds (Rabobank issued $350 million of bonds at a coupon of 5.8%).

Despite risks created by the low interest rate environment, we continue to find attractive investment opportunities. For example,in addition to our continued optimism about the prospects for well managed global equity income funds, we are finding otherpockets of excellent value within equity markets. Opportunities include shares in companies listed in developed markets benefitingfrom the strong economic growth in emerging markets, and equities of companies operating in industries exposed to the need forenvironmentally sound practices to facilitate sustainable economic growth.We also feel that the recent setback in the Japanese equitymarket has been overdone, and believe that the upside potential for this perennially disappointing market is now considerablygreater than its downside risk.While we are mindful of the threat of high volatility in equity prices, we feel that valuations justify areasonable allocation to shares. Many investors are favouring the comparative safety of bonds, but this has led to a situation whereinvestors are getting paid for taking risk. For example, Johnson & Johnson recently issued 10 year bonds at a coupon of just 2.95%,around 0.5% less than the yield on its shares, even though the company has managed to increase its dividend in each of the past48 years!

Conclusion

Investors thrive on certainty. The easiest time to make confident investments is when there are clearly identifiable and durabletrends. Unfortunately “an era of low predictability (when) anything could happen” does not give investors that luxury. Rather thandenying that fact, it is prudent to invest in the light of it by holding sensibly diversified portfolios that are not dependent on adefinite economic forecast which may or may not work out. The investment environment is challenging because one featureinvestors will need to get used to will be the lack of clear trends and the on-going volatility of economic indicators and asset prices.The response to this environment should not be to stop investing, but instead to be adaptable and to use the volatility of marketsto take advantage of periods when over-confidence or pessimism forces asset prices to levels that common sense would suggestare unjustified.We view the current fears of deflation in this way, in the sense that, as deflation fears have become overly embeddedin asset prices, we have taken the view that government bonds are over-priced relative to some other quality assets and haveconstructed portfolios accordingly. We continue to favour the shares and bonds of companies with strong finances and globalbusinesses, and specialist funds managed by those following an active approach who are able to take advantage of volatile conditionsin financial markets and the opportunities this will create.

Richard Scott30th September 2010

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