Threadneedle: market conditions

Risk assets in general have had a dreadful start to 2008 with increasing fears of a recession in the US driving markets significantly lower.

In addition investors have worried that the monoline insurers, that have insured some $2.5trn of municipal bonds and asset backed securities (ABS), could default. This has exacerbated the concerns, according to Dominic Rossi, Head of International Equities at Threadneedle.

The US economy is clearly in a weak state but we have already seen the Federal Reserve being proactive in cutting rates aggressively. Falling inflationary pressure, helped by a lower oil price, should enable official rates to fall materially. Bush’s proposed fiscal package of 1% of GDP may provide some additional help. Rossi also believes the monoline insurers could receive some government support in light of the collateral damage that any failure would cause. This would be taken well by the market. He expects US GDP growth to be well below trend but still positive in 2008 and for market earnings to be in the same ballpark as 2007.

Rossi believes global equity markets are discounting a worse scenario than envisaged. Risk appetite has fallen to panic levels and volatility has risen sharply. Valuations in terms of PE ratios, even on cautious earnings assumptions, have come down to very low levels by historical standards. Similarly, relative to government bonds, equity valuations appear at the low end of ranges. While volatility is likely to remain high in the immediate future, Rossi believes equity markets offer good value for medium-term investors.

Threadneedle’s preferred equity markets remain those of Asia and the Emerging Markets. These regions will feel some impact from a sluggish US economy but the momentum of continued domestic consumption should enable good economic growth compared to developed economies. Our funds have benefited from favouring these markets and, although they have performed well over the last year and may be vulnerable to profit taking, we believe they are still attractively priced.

In the second half of 2007, Threadneedle funds increased their bias towards defensive stocks. They have added to sectors such as healthcare, energy and telcos, which have limited gearing to economies, and reduced more cyclical areas such as industrials. They have been underweight in financials for some time, particularly banks, being concerned about rising bad debts and slower loan growth in developed economies. We have also focused on companies with strong balance sheets, experienced management and an ability to give reasonable earnings growth. Threadneedle have favoured large caps over the more cyclical and expensive mid and small caps. This has left our funds in an excellent position for market conditions over recent months. Rossi expects a continuation of tough conditions for companies to operate under and Threadneedle is therefore broadly retaining this defensive stance. However, he can see value appearing in some of the worst performing areas of markets, such as banks, and will consider adding to holdings in these areas.

Government bonds have performed well in the recent turmoil while spreads in Emerging Market bonds and High Yield bonds have widened considerably. Emerging Market fundamentals continue to be robust and high yield spreads are now discounting very high levels of default. Rossi sees current spreads beginning to offer good value.

There is considerable uncertainty in global markets and volatility is likely to remain high. In recent weeks markets have moved to discount an extremely weak global environment. We believe this offers attractive valuation levels in a number of risk assets for medium-term investors.