We're sticking with equities

Apr 7 2010 by Andrew Miller, The Journal

HERE at Barclays Wealth, we formally review our asset allocation recommendations on a quarterly basis. This time around, as we enter the second quarter, the danger facing the global economy and markets seems clear and very present.

Consumer confidence remains fragile, overshadowed by weak labour markets, yet interest rates – and probably taxes too – will have to rise at some stage. In the emerging world, central banks in some of the largest emerging economies have already started “to take away the punch bowl”, in the words of former US Federal Reserve chairman William McChesney Martin Jr. And in Europe, the precarious nature of some government budgets has been brought to investors’ attention by the turmoil in Greece and the slide in the euro.

Clear and present dangers are risks that may be at least partly priced in, however. Indeed, very slowly, investors’ risk appetite seems if anything to be gradually returning – encouraged, perhaps, by the decline in implied equity volatility.

This can be seen, indirectly at least, in continuing outflows from “safe haven” money market funds in the US. On this front, there is potentially much more to follow. As we’ve discussed in previous editions of this column, there is still some US$3 trillion – equivalent to about 30% of the S&P 500’s market capitalisation – sheltering in such funds, an amount well above pre-crisis norms, and indeed above the earlier peak seen in 2002.

Meanwhile, economists’ and investors’ worst fears of six months ago – of an abrupt reversal in the incipient recovery in the global economy and financial markets – have not come to pass, and for good reason. Both companies and households together are generating free cash flow on a scale not seen in recent memory. The major central banks are also continuing to advise that they are in no hurry to raise official interest rates.

And even in the hard-pressed eurozone, where we think the risks of monetary disintegration have been overstated, the weaker euro will help support exports and overseas earnings – not that Greece should expect a vote of thanks from other eurozone states any time soon.

For good measure, the valuation of equity markets in particular remains undemanding, in our view. The additional rally in 2010 to date has been associated with further – plausible – upgrades to consensus expectations of profits growth and, as a result, prospective price/earnings ratios remain below what we view as the relevant long-term averages.

Valuation metrics that relate these multiples or dividend yields to the general level of long-term interest rates show equities to be more materially undervalued.

On balance, then, as in the first quarter of 2010 and the fourth quarter of 2009, we think that equities are likely to remain the best-performing of the traditional asset classes, and we stay overweight in them. The gains in prospect in 2010 – particularly from current levels – are, of course, likely to fall short of those seen in 2009 and, as a result, we think that the importance of active investment management may be higher than it was last year.

But our index targets have not been over ambitious, and the prospective level of earnings may be a little higher than we thought at the start of the year, suggesting a bit more headroom for equities.

Andrew Miller is head of Barclays Wealth office in Newcastle