A contradictory message is being sent out to investors
Do not be suspicious of equities and bonds being positively correlated. A current theme of analysts' conversations is the apparently contradictory message that the recent rally in both equities and government bonds appears to be giving. After all, a rally in equities suggests confidence in earnings projections and in growth of demand, while a rally in bonds suggests the opposite scenario of low growth with fears of deflation caused by weak demand.
Yet this is to forget that bond and equity markets are not always locked into a zero sum game of 'I win, you lose.' Declining yields in the US over the past six weeks do not necessarily imply growing pessimism on the growth outlook, but more confidence that rising inflation will not be a threat within the context of improved growth expectations, which will be supportive of earnings and stock markets.
So temporarily, everyone is happy. Bond markets are relieved that the Fed sees no threat of inflation, while equities take heart from the Fed's promise to do everything possible to avoid deflation. But the balance of risk must surely favour equities in the longer term. Bonds appear to be the more exposed of the two asset classes, given the determination of the Fed to avoid deflation together with the issue of over-supply as the western governments increase their borrowing to pay for greater fiscal spending.
As things currently stand, it would take a brave investor to bet against the prospect of a pick up in global growth over the next 12 months, and to favour bonds at the expense of equities. That at least is the stance we are taking in our balanced portfolios, which favour equities over bonds.
Global Equity Portfolio Asset Allocation: In our global equity portfolios we are overweight the UK and emerging markets. Continental Europe has a poor economic outlook, with the monetary and fiscal policies associated with euro membership contributing to recessionary conditions in Germany. The region is neutral in our portfolios. We are underweight Japan and the US market, as current valuations appear stretched compared with its own history and relative to other major markets.
The UK: Given the importance of exports and foreign earnings to many listed UK companies, any improvement in the global economy will have a large influence on UK stock market performance. Equity valuations are relatively cheap on a historical basis and compared to gilts, while with sterling weakening against the euro, corporate earnings appear to be well supported.
Pacific ex Japan: The region's stock markets continue to depend on growth in the West, particularly in IT investment spending. Nasdaq's 9% rise in May, and a corresponding rally in the Asian tech stocks, in part reflected a recovery in US capital expenditure. But of equal interest to investors ' due to its potential as a consumer as well as an exporter ' is China. Anecdotal evidence suggests that Sars has hit consumer spending, which has been growing rapidly in recent years, but the export sector has not been materially affected.
Tom Elliott is strategist at JP Morgan Fleming
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