2. 2009 a year of paradox
2009 was a year of paradox. While it was a year when the UK economy was mired
in recession and government finances spiralled out of control, it was nevertheless a
great year for investing in financial markets. This paradox proves that investing
successfully is about assessing what is currently discounted in the valuation of an asset,
and then judging whether that is fair. If assets are cheap enough then they can perform
well even through a recession. A year ago we concluded we were “excitedly optimistic
about the prospective performance of some investments, even while holding a
realistically downbeat view for the economic outlook” (Hawksmoor Investment
Outlook for 2009 December 2008). Looking ahead to 2010 we continue to hold a
downbeat economic outlook, and given the sharp rally in many asset prices we feel
a much more discerning approach will be required to make money than proved to
be the case in 2009.
A year ago the valuations of many “risk assets” (such as shares, commercial property and corporate bonds) were extremely depressed
and looked cheap even should there be a prolonged economic slump. A year later, after a substantial rally, this is no longer the case
and there is a risk that the strength of the economic recovery discounted in some areas of financial markets will turn out to be too
optimistic. There are very stiff headwinds to growth that are likely to become increasingly apparent as we go through 2010. These
headwinds have been created by the lingering wounds to the global financial system from the Credit Crisis and the need to reverse
some of the emergency fiscal and monetary measures that were adopted to prevent a collapse of the banking sector and a deflationary
slump. Nevertheless, as the American writer William A.Ward observed,“the pessimist complains about the wind; the optimist expects
it to change; the realist adjusts the sails.” By acknowledging the difficulties of the economic climate which we face we have been
“adjusting our sails”, endeavouring to find the best areas of financial markets in a difficult environment. Fortunately, even though we
are cautious about the economic outlook, we continue to find attractive investment opportunities, even though it is important to be
realistic about the prospect for much lower returns than we saw last year.
An end to Quantitative Easing?
When assessing the current valuation of investments it is important to remember that the spectacular rises in share and corporate
bond prices since March 2009 occurred from abnormally depressed levels. Valuations became extreme because for a time it was
possible that a deflationary slump would develop leading to a raft of bankruptcies and defaults. Many of the companies that have since
seen their share prices lead the market rally came close to financial disaster early in the year, and it was only the re-opening of credit
markets in the Spring that enabled them to refinance their enfeebled balance sheets and survive.This shows how vital the adoption
of Quantitative Easing (QE) by western central banks was to lay the basis for the recovery in asset markets. Coming on the back of
slashing interest rates close to zero, the authorities adopted QE to inject vast amounts of liquidity into the financial system by purchasing
bonds with newly-created money. The combination of receiving this cash for the bonds sold to central banks and the pitiful interest
rates available for holding cash on deposit meant money suddenly flooded into financial assets, fuelling a recovery in prices and enabling
companies to issue new bonds and shares. Understanding this background is vital in looking forward to assess what is likely to happen
in 2010. This is because in formulating an investment strategy it is necessary to judge what will happen to financial markets when
emergency liquidity measures are withdrawn.The period we have seen of QE is without precedent, and in our opinion the popular
strategy of extrapolating the performance of asset prices following past economic recoveries is not appropriate for current conditions.
We believe we are at a pivotal point during which the world economy is transferring from growth led by debt-driven consumerism
in western developed nations to growth led by continuing strength in emerging economies. However, while the strength of emerging
economies will provide some support for western nations it will only temper what is likely to be a period of greater austerity for
developed economies during which debt will need to be paid down and inflationary risks will be building. If this sounds too gloomy
and we are pleasantly surprised, then we would prefer that to the alternative! However, a cautious approach is warranted. This involves
having a diversified portfolio of investments that are not all positively correlated with one another, and responding flexibly to changes
in the environment when they become apparent.
3. Our investment strategy for 2010
The starting point to any investment strategy should be to assess the likely prospective returns of an asset compared to the risk free
rate of return. In this respect the returns offered by the lowest risk investments such as cash and short term government bonds remain
exceptionally low, and unattractive for all but those who believe most asset prices are set to fall. While we believe that financial
markets will be far less buoyant in 2010 than 2009, and that prices in some areas look vulnerable to bad news, we continue to hold
very low levels of cash, reflecting our view that financial markets hold attractive opportunities. Our attitude to corporate bonds
illustrates this. A year ago we believed that corporate bonds would deliver strong total returns, given the scope for their prices to
recover. Even though the scope for capital gains is now modest, we still feel that that talented bond managers who actively manage
their portfolios and hedge interest rate risk should be able to produce returns that beat the risk free rate of return by a considerable
margin. By contrast, we remain negative on the prospects for most government bonds, notably those in economies set to struggle
with huge public deficits. For example, QE has kept UK Gilt yields artificially low and the risk of a sharp rise in yields is increasing,
given the weak state of public finances and the future threats of inflationary consequences to the authorities’ measures to counter
the recession.
Although we remain optimistic about the economic outlook for emerging markets we believe that some of the most attractive
investment opportunities to benefit from growth in the emerging world are the shares of major companies quoted in developed
markets including the UK. Over 70% of UK corporate earnings are now derived from overseas, and the valuation of many large
dependable companies with global franchises quoted in developed markets around the world look attractive. We particularly favour
those paying significant and sustainable dividends. Reflecting this among the core holdings in our portfolios are well managed global
equity income funds delivering income at a level well in excess of that of 10 year government bonds and with scope to see increases
in distributions. We have also made investments in high quality UK commercial property vehicles following the sharp sell-off, in the
expectation that a decent level of income combined with some albeit modest, scope for a recovery in capital values will prove to be
an attractive proposition relative to cash.
We have recently been increasing our exposure to one of the laggards in 2009 - Japanese equities. With over half of Japanese exports
now destined for other parts of Asia, the Japanese equity market is fast becoming the forgotten poor relation of the Asian growth story.
Moreover, around 20% of Japanese listed companies trade below book value, have net cash on their balance sheets and are profitable
- a level of extreme value seen in only a handful of cases in most other equity markets. Investment in Japan also provides diversification
benefits: Japan is the only major developed market yet to benefit from surging liquidity in this cycle and we believe it is unique as a
market that would benefit rather than suffer if inflation were to become a global concern.
Conclusion
Investment is a long term game played out in a multitude of short intervals. Writing a quarterly investment outlook is a reminder of
this and it creates a temptation to change stance too frequently or to underestimate the importance of major long term driving forces
in financial markets. We therefore need to balance an approach that backs long term investment themes with making tactical changes
to adapt to a fast-changing environment. The past eighteen months has been a highly unusual period in which asset prices have been
on a roller-coaster of plunging and soaring movements reacting to events of an historic magnitude. Just as investors over-reacted to
bad news pushing prices too low, we feel that they have over-reacted during the bounce-back, pushing some prices too high. In doing
this, high quality investments have often been ignored in favour of those most sensitive to a strong economic recovery.The good news
is that this has created opportunities to rotate our portfolios, buying high quality investments at a discount or, as one of our favoured
fund managers John Wood of JO Hambro put it, to find “Waitrose-quality companies that are valued at Aldi prices.” 2010 is highly
unlikely to be as rewarding as 2009, but by a careful approach seeking quality, dependable income streams and modestly valued
investments exposed to high growth areas we hope to provide another good year of performance for our clients.
Richard Scott
21st December 2009
HA076
4. Waterfront House
Wherry Quay
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t: 01473 261300
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Exeter
Devon EX1 1QT
t: 01392 410180
e: info@hawksmoorim.co.uk
www.hawksmoorim.co.uk
This document is provided for information purposes only and should not be interpreted as investment
advice. Whilst the information contained in this document has been prepared in good faith, no
representation or warranty, express or implied, is given by Hawksmoor Investment Management Limited
or any of its Directors, partners, officers, affiliates or employees. Past performance is not a guide to future
performance. HA047
Hawksmoor Investment Management Limited is authorised & regulated by the Financial Services Authority
Incorporated in England & Wales • Company Number 6307442 HA047
