Article

Reasons to be nervous - John Redwood Comment

February 19, 2010

I feel very nervous about investments.

Markets have had a good week. January’s modest losses have more or less been erased. The Fed has announced we should expect better growth this year in the USA. The Greek crisis has not deteriorated further. Barclays announced bumper profits and a much stronger balance sheet. Many in the markets have gone back to thinking this is a normal cycle, where re-stocking will give way to increased final demand. The recovery may be slower and longer, but there will be enough easy money around to ensure a recovery of sorts. In this situation markets should afford modest positive returns for patient investors.

So why do I feel nervous? I am concerned because the main imbalances in the world economy that lay behind the crash are not being sorted out rapidly.

Interest rates have to rise from here. In China they have made a start towards normalising credit conditions by restricting bank lending. In India rapid inflation requires higher interest rates to cool it all. Australia has started raising rates. The USA made a first modest step with a 0.25% increase in the discount rate for banks. In the UK, Greece and elsewhere high borrowing is leading to higher government bond yields.

Banks have been propped up by government actions, and some banks are trading themselves out of difficulty by making huge profits in their investment banking arms. In both the UK and the US there remain concealed big problems with debts secured on property. As Regulators demand more cash and capital for any level of business, so returns on banking capital fall and less money is available for business to expand.

The Euro is devaluing gently as investors reappraise the risks involved in a currency based on very different economies and public debt levels. The Euro sovereign debt crisis may not be over, as the countries at risk may not yet have taken enough action to curb their deficits. The UK public deficit is growing rapidly as expected. That too may not be sustainable short of convincing government action to tame it.

The Japanese, Germans and Chinese still want to run their economies on an export-led model, at a time when their principal customers in the West are having to rein in their appetite for more consumption financed by borrowing. The US and UK consumer is having to repay debt or make do with lower earnings as the recession forces more into part time working or unemployment.

So where should an investor go from here? We still think there is more risk in the heavily borrowed and slow growth territories than in the fast growth areas of the world. We remain negative on gilts and some other European country bonds, as we expect further rises in interest rates to reflect the deficit risks. It is time to have a balanced portfolio investing in markets where there is sustainable and growing income. It is time to hold less risk than in 2009 and to expect less good returns. 2010 is proving to be hard work for investors, as we feared. Asian property, corporate bonds and some emerging market equity is probably about as good as it gets.

Regards,
Evercore Pan-Asset Team