Few signs of double dip but investors are still nervous

Jul 14 2010 by Andrew Miller, The Journal

MARKET volatility has abated somewhat over the last week - or at least it has become a little more balanced, with the prices of risk assets rising for a change.

However, we doubt whether volatility will fall much further during the summer months. We still see few signs of the dreaded economic “double dip”, but the jury will be out until economic leading indicators have visibly stabilised, which seems unlikely until closer to the year-end. In the meantime, investors are quite likely to react nervously to any signs of slowdown, no matter how immaterial.

Independent of the economic data, there may be plenty of opportunities for such nerves as the second quarter US earnings season gets under way and the results of the stress tests for European banks are published in the weeks ahead. As far as corporate profits are concerned, after the bumper results posted in the last two quarters, it would be astounding if growth rates didn’t fade somewhat, simply because year-ago comparisons must start to become less friendly. In the normal scheme of things, such an innocuous slowdown might have little impact, but in today’s febrile climate, who can say? Investment banking at least seems to have the potential to deliver some genuine disappointment in this particular quarter.

We expect investors to continue to adopt a distinctly “bimodal” world view in which an extreme outcome – in either a deflationary or a pro-cyclical direction – is believed more likely than a “muddle through” one. Currently, we favour a somewhat unconventional asset allocation which is designed to reflect these unconventional and volatile expectations – namely a “barbell” strategy in which we are overweight both high-quality long-term government bonds and equities (and high-yield credit) at the same time.

Of course, our strategy might not work too well if the gains on the equity overweight were cancelled by losses on the bond overweight, or vice versa, but two developments of late seem to us to minimise the chances of this happening. First, the floor for bond prices is likely to have been raised owing to the fact that interest rates seem unlikely to rise soon on either side of the Atlantic – a major sell-off in long-dated bonds looks unlikely with cash rates tethered (as we found earlier this year). Second, equity valuations are flirting with the lows seen back in 2009, suggesting that some support might increasingly limit losses there.

One of the questions we had when we unveiled this strategy was whether such a portfolio mix has worked in the past. Our initial response was to say that we haven’t seen such bimodal expectations in recent memory. That said, on further reflection, we realised that the bulk of the financial gains seen through the 1980s and 1990s took exactly this form – namely, bonds and stocks rallying together, and each outperforming cash. The drivers, of course, were somewhat different – specifically sustained disinflation alongside healthy growth and restrained volatility. Even the optimists among us see less room for such an outturn given the current starting point!

:: Andrew Miller is regional office head of Barclays Wealth in Newcastle