Recovery on course despite the odd squall

Mar 3 2010 by Andrew Miller, The Journal

IN recent weeks, worries about Greece and some other Euro- area economies, as well as news of moves to restrict loan growth in China, have both caused the markets particular concern.

The good news is that, at this stage, the ongoing economic recovery appears robust enough to withstand such headwinds.

Greece’s problems have been well covered in the press recently but China’s attempts to curb its breakneck speed of economic growth have attracted rather less attention.

We continue to think that Greece’s problems can be resolved, and a default avoided, although the detail here remains sketchy. We also think that the risk of a default in other fiscally-challenged EU states – such as Spain – remains small.

In contrast to Greece, China has been a victim of its own success. Worried about inflation and excessive credit expansion, the Chinese authorities have been tightening banks’ reserve requirements for some months now.

Given recent action by Chinese policymakers, we think that benchmark Chinese interest rates are likely to rise at some point in the next three months.

However, worries that either of these issues could derail global economic recovery look misplaced in our view. Recent business surveys have been positive, and leading indicators – indicators that change direction before the economy itself – suggest that recovery looks set to continue in coming months.

Perhaps even more importantly, policymakers in the developed world now also seem confident enough to start winding down emergency policies implemented during the financial crisis.

In the UK, the Bank of England has halted its programme of gilt purchases. The US Federal Reserve is wrapping up its intervention in the mortgage-backed security and federal agency debt markets, having already closed down a host of extraordinary liquidity programmes. And the European Central Bank has indicated that it will outline the phasing-out of its liquidity initiatives following its March meeting.

But, even if we are increasingly confident that economic recovery can be sustained, what does this mean for investment strategy? At the moment, we aren’t concerned by the recent levels of volatility, but are well aware that market’s mood can develop a momentum of its own.

Of course, if Greece’s problems eventually prompt a more substantial sell-off in the government bond markets, then equity yields would start to look less attractive.

But, at present, we keep a “mid cycle” preference for corporate paper ahead of government debt, with developed market equities our favourite asset class, and cash the least preferred.

However, we also think that it’s worth keeping an eye on the future, and risk-averse investors may want to purchase some short-term portfolio protection in order to guard against any substantial short-term market downturns.

We would also recommend that within cash allocations – while an unattractive and low-yielding asset in itself – investors should return to “business as usual” as much as possible and prioritise liquidity over income considerations. Many investors were tempted to buy short-dated government bonds as a means of supplementing the meagre returns available on cash deposits over the past 18 months, but we no longer feel that this is an appropriate strategy.

In short, we feel that the additional income offered by such securities (relative to normal cash deposits) simply no longer offsets the risk of holding them, particularly given the ongoing fiscal imbalances in the developed world and the likelihood of interest rate rises before the year is out.

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