martedì 1 settembre 2009

September calls for a prudent asset allocation

Major international stock indices rose in August as the downward trend in the market risk premium, which began in March, continued. The expected upturn in economic activity in the months to come is the main reason for the positive equity market momentum. These expectations were reinforced in mid-August by Fed Chairman Bernanke’s statement during the Federal Reserve Bank of Kansas City's Annual Economic Symposium in Jackson Hole. Indeed, the Fed chairman, who was confirmed for a second four-year term by President Obama, said “Economic activity appears to be levelling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good”.

The last few weeks have brought a spate of forecast-beating economic data, which have strengthened expectations of an upswing in leading international economies. In the U.S., optimism has been fuelled by encouraging data from the housing sector. Reassuring signals have also come from improving consumer and business confidence indices (the ISM manufacturing exceeded the 50 threshold, which anticipates a return to growth in the manufacturing sector).

In the Euro area broadly positive news came from France and Germany. Surprisingly, both countries saw positive GDP growth rates in Q2, as clear evidence that the recession may have already ended for the two largest economies in the region. These figures also gave grounds for optimism over the whole of the Euro area economy, albeit the overall Q2 GDP figure remained in negative territory.
The possibility that the economic outlook will continue to improve in the coming months thanks to the strong monetary and fiscal stimulus implemented by the Governments and Central Banks in recent months should help lift major stock indices going forward.

A return to economic growth would bring investors to discount a sharper increase in corporate earnings in the coming quarters. A positive signal for the stock market is also the high spread between the 3-month T-Bill and the 10-year T-Bond, which has historically been followed by marked increases in U.S. indices.

For these reasons some investors are looking for sharp increases in equity markets over the coming months. According to Laszlo Birinyi of Birinyi Associates, the S&P500 may rise up to 1700 points during the next two to three years.

Nevertheless, we see many reasons to stay cautious on international indices in the short term, particularly due to seasonal factors. Indeed, September is a historically negative month for the U.S. and major international stock markets.

Moreover, following the rally staged since last March, major international stock indices do not appear to be cheap any longer. For example, the price/ average earnings for the past 10 years ratio, after plunging to 13.3x in March, its lowest since 1986, has now risen to 17x, a level in line with its long-term average.

Therefore, we recommend selecting a prudent short-term equity market asset allocation in September. This is particularly true for emerging markets indices, as shown by the steep decline in the Chinese stock market in August (the Shanghai Stock Exchange lost around 15%).

Moreover, market expectations for economic growth going forward may prove to be overly optimistic. On the one hand, some Central Banks have begun to entertain the possibility of raising rates (the Central Bank of Israel was the first CB to lift rates on 24 August, from 0.50% to 0.75%), on the other hand the Fed and ECB seem eager to wait much longer to reverse the current expansionary monetary policy as they believe that the incipient economic recovery is still fragile. Among major international central banks, the Bank of England pursued an even more aggressive expansionary policy in August by increasing its Asset Repurchase Programme. The BoE Governor, Mervyn King, suggested that a return to economic growth in line with the average of the past would not be enough to regain the ground lost in the past two years.

With major international Central Banks unlikely to reverse their expansionary monetary policy any time soon, short-term Government Bonds in both the U.S. and Euro area should continue to be a safe haven for risk-averse investors, as the chances of a steep rise in yields look slim, at least in the near future. In particular, European investors should continue to invest in European securities given the uncertainties surrounding the U.S. dollar. Risks seem to be contained even for long-term Government Bonds as fears of a strong increase in inflation as a result of the expansionary monetary policies implemented in recent years should not materialise in the months ahead.

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