Euan Muro: In January 2011, we will be able to look back and explain exactly which asset classes fund managers should have been investing in to be awarded hero status. It may be that emerging markets with the commodities that China needs will be the dominant theme, or perhaps a stall in global growth will dash the fragile confidence of investors and high grade bonds will win out.
Diversified managers ought not to try to be a hero, however. Extraordinary uncertainty exists at this point in the economic recovery; much depends on the decisions of the world’s central bankers, regulators and politicians. This is why we believe the investment outcome for a properly diversified fund should not be totally dependent on how 2010 turns out.
The term ‘balanced fund’ conveys a comforting sense of diversification; perhaps it will cope with many of the possible versions of 2010 that lie ahead. However, this is unfortunately not the case. The average UK balanced fund has a weighting of around 75% in equity markets, which is extremely concentrated and means we should not expect such funds to do much more than deliver slightly diluted stock market performance.
Given stock markets globally will be up modestly in 2010, we would expect the average balanced fund to deliver a slight positive return. But that is just the central view; it is more in keeping with the spirit of diversification, to consider how funds will do in a variety of possible economic scenarios, including the central one.
We run our diversified absolute return funds through a range of scenarios, from a bleak future, where the stock market falls substantially and the world again teeters on the brink of deflation; to a rosy future, where confidence rebuilds remarkably quickly and equities rally strongly.
When we apply this analysis to a typical balanced fund, it says it will deliver a return of around 2%-3% in 2010 on our central scenario. However, the simple average return across all the future scenarios considered is a worrying -8%. Even if we assign a probability of 60% to the central scenario being correct, it still gives an expected return of -2.5%.
Better diversification can be achieved. For example, our diversified global absolute return fund, when run through the same theoretical scenarios, is expected to return around 8% in the central scenario, 3% when averaged across all scenarios and almost 6% if the central scenario has a 60% probability.
The inevitable conclusion is that while we expect the average balanced fund to deliver a small positive return in 2010, balanced funds are not really very balanced and are ill-equipped to cope with the enormous uncertainty that still lies ahead.
|
Percival Stanion (pic right) is chairman of the strategic policy group at Baring Asset Management |
Percival Stanion: While 2009 saw an indiscriminate rally in financial assets, we expect this year to be tougher going. The real economy will of course be much healthier than last year. Even laggards like the UK should manage to show modest growth by the mid year, while the US should be growing at 2.5%-3% in GDP terms. Emerging market economies will continue to lead the pack, with China likely to be exceeding 8.5% growth.
But this moderate economic recovery is already priced into financial markets and even this relatively benign scenario still contains risks. The most significant risk concerns the reaction to the withdrawal of government stimulus. Quantitative easing will come to an end over the next few months. The effect of this is likely to be a modest rise in government bond yields in the UK, while in the US we expect mortgage rates to rise by 25-50 basis points. The key questions are can a fragile consumer sector cope with this slight squeeze? Will the nascent recovery in the housing market be nipped in the bud?
So far the evidence is positive, but not conclusive. The end of the cash-for-clunkers programme in the US has not seen a collapse in the car market.
Employment is another weak spot. There are signs that layoffs have ended and unemployment levels are stabilising. Normally, we would expect to see overtime hours rising followed by an improvement in job creation later in the year. We will certainly get some help from temporary hiring in the US for the census, which will add half a million positions. But most job creation is among small businesses and, here, there are still signs that the lack of credit availability may be having an impact. In the UK, we also have to weigh up the impact on consumers of higher VAT rates and the prospect that whichever government is elected, a fiscal squeeze will pace a limit on growth for several years.
So looking at asset prices this year, progress will be more muted and investors need to be more disciplined in selecting their entry points. For equities, most markets now look fair value, but you have to factor in a strong bounce in earnings. This is probably justified, given the huge amount of cost-cutting already achieved, but beyond that short-term benefit the markets will want to see signs of top-line growth. We have lightened up on positions in the expectation that equities will see some profit-taking after last year’s surge and while investors evaluate the normalisation of monetary policy. This should provide some better buying opportunities over the next few months.
Government bonds look poor value in the UK ahead of a huge increase in issuance that will not be supported by Bank of England buying. We prefer German bonds in that area. Corporate bonds have also staged a huge rally and we have become profit-takers there. Overall, the next few months could see increased volatility and investors should be adopting a slightly more cautious approach until they have greater clarity on the resilience of the economic recovery.
