Stock markets running out of steam

Dec 2 2009 by Andrew Miller, The Journal

AFTER a stellar run since March, equity markets ran out off of puff in October. Since then, stock markets have failed to perform at anything like their pre-October pace.

More recently, they have been rattled by events in the Middle East. But does this mean that the recovery in financial markets is now over?

First, it is important to stress that, from here, markets are unlikely to rise at anything like the pace seen in the second and third quarters, while areas that have already performed particularly well – such as emerging markets – can no longer be regarded as being “cheap”.

However, given the recovery in corporate profits, the still-friendly interest rate environment around the world and undemanding equity valuations, we think that stock markets can make some further headway in the short term.

Indeed, in our view, investors should be adopting a “business as usual” approach to their investment portfolios if they have not done so already.

But while we believe that the outlook for equity markets is still favourable – especially when compared to Government bonds, where yields look too low and prices still too high – difficult macroeconomic challenges still lie ahead. The manner in which policymakers handle these challenges will have significant implications for financial markets.

On the monetary policy front, we expect “official” interest rates to rise in the US, UK and Euro area in 2010 – but only modestly.

In the UK, we expect rates to hit 1.0% by the end of 2010, while in Europe we expect rates to rise to 1.5%. In the US, we expect the federal funds policy rate to rise to 0.75%.

However, while official interest rates are important and will provide a focus of media attention when they do rise, movements in long-term interest rates are likely to have a significant impact on investor behaviour in 2010.

The rescue of the financial system, while successful, has also been costly (particularly in the US and UK) and this means that investors are likely to take a much less positive view of Government-guaranteed debt than they did during the worst days of the crisis. In particular, we believe that the prices of long-dated Government bonds could decline significantly in the US and UK, reflecting the fact that US and UK Government debt will inevitably be regarded as more “risky” by investors due to the hefty bill for bailing out the financial system.

By contrast, as the European Central Bank has emerged from the crisis as the major central bank with the most credibility, euro-area bond prices should not weaken as much as those in the US and UK.

However, the prices of longer-dated Government bonds generally are likely to be under some pressure next year – even in the EU, the ECB puts the cost of rescuing the financial system at around 26% of GDP.

Given these concerns and the strong likelihood of higher “official” rates, we think shorter-dated Government bonds remain preferable to longer-dated ones and, within this, euro-area bonds look a better bet than those of the US and UK.

All in all, 2010 should see normality continue to return to markets. However, governments in the US and UK undeniably face very tough fiscal decisions, and the way in which these are dealt with could have a very significant impact on how investors regard their debt.

Andrew Miller is regional office head of Barclays Wealth in Newcastle