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Investment
Quarterly - Q3 06:
Third quarter 06 market overview |
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| While
Middle East conflict continues to push up oil prices and spark
fears over inflation and weakening economic performance, UK
markets still appear inexpensive; though diversification remains
key, says Alistair Peel |
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George
Bush’s ‘Axis of Evil’ was much to the fore
in the third quarter of 2006. North Korea fired missiles towards
Japan and extended the range of their weapons towards the
USA; Iran continues to develop its nuclear capacity; Iraq
continues to be a grave for too many US soldiers and Syria
and Iran provided weapons for Hezbollah in their fight with
Israel, who re-invaded the Lebanon. Further terrorist atrocities
included a bomb attack in Mumbai during the rush hour and
in August, an alleged plot to blow up transatlantic commercial
aircraft was foiled by UK security forces.
The impact of the conflicts within the Middle East saw the
oil price spike sharply higher, adding to concerns over inflation
and a weakening economic performance. Markets were supported
by a hint from Mr Bernanke that interest rates in the US had
probably peaked at 5.25%, following a rise at the end of June
– and there was no rise in July for the first time in
18 meetings. Bond prices were slightly stronger in July as
the interest rate outlook improved and there was a flight
to quality by investors seeking defensive assets.
In the UK, a flat market was boosted in the short-term by
some strong figures in July from the oil majors, which benefited
from the stubbornly high oil price, and Northern Rock, Reuters
and Rolls Royce beating market forecasts. Takeover activity
continued during the quarter with Xstrata bidding for Falconbridge,
and House of Fraser and AB Ports also receiving bids.
Looking forward, valuations appear attractive as the price/earnings
(p/e) multiple suggests the market is inexpensive. The current
p/e is a modest 11.9 times, falling to around 11.3 for next
year, which compares very favourably with the 15 year average
of 16.3 times, and the dividend yield is still an attractive
3.2% (source: Halbis August 2006).
In the US, however, we do anticipate a slowdown: we expect
GDP growth to remain reasonable at about 2.5-3% in 2007 and
activity is softening, but growth is not going to be way below
trend. The second quarter GDP figure was weaker than expected
at 2.5%, sharply down from 5.6% in the first quarter, and
core inflation is trending up, but from a low level. The market
looks to offer fair value as the p/e ratio is 14.2 times,
still some way below the long-term average of 16.3 times,
and up to 10% growth is expected in earnings in 2007 (source:
Halbis August 2006).
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Positive economic numbers and strong corporate results cancelled
out the negative implications of the geopolitical situation
at the start of the third quarter in European markets. Unsurprisingly,
the European Central Bank raised interest rates to 3% which
had minimal impact on the markets as it had already been priced
in. Economic growth is still marginally above trend at about
2.5% and employment is rising. Confidence levels appear high
and it is hoped that demand will increase in mainland Europe
over the next few quarters (source: Bloomberg August 2006).
Japanese markets had a weak start to the quarter as they were
unnerved by North Korea’s missile tests and the high
oil price. Japan is still fragile in some areas, such as retail
sales, but GDP data has clearly improved and overall domestic
demand is reasonably firm. We expect 3% growth for the full
year.
Emerging markets have had a difficult quarter as investors
became more risk averse due to geopolitical considerations.
However, economic growth continues to surge ahead in India
and China where GDP is still growing between 7% and 9% per
annum. The Chinese market is up 30% year-to-date but is still
only on a p/e of about 15 times (source: MSCI Chinese Index,
Bloomberg).
From an asset allocation perspective we prefer equities to
bonds and also cash to bonds. Alternative investments such
as hedge funds and property should also have a place in a
well diversified portfolio. For balanced funds an exposure
of between 5% and 10% to hedge funds (preferably via a fund
of hedge funds) would be a reasonable level and in larger
funds a similar exposure to private equity funds and property
would also seem reasonable. We believe that total exposure
to alternative investments could be as high as 25%.
Investment in unconstrained funds should also be considered
and an absolute return fund should provide some downside protection
as well as providing returns ahead of cash.
Alistair Peel is director, charity services at
HSBC Investments
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