The Investment Environment

Heading into the fourth quarter of 2010, there seems to be if not a shining light, then at least a dull glow at the end of the financial tunnel as David Chapman, Director of BlackRock, reports.

The consensus among professionals is that the chances of a double dip recession – where the economy re-enters recession after a brief growth phase – are unlikely, though more probable in the US than in the UK and Europe. That said, as the effects of policy stimulus in the wake of the financial crisis have worn off, lacklustre economic data and growth figures from the United States, as well as China’s slowdown in the property and manufacturing markets have made for muted momentum in the global recovery for the second half of 2010. We are not surprised, however, by this slow-down, given that the level of robust activity that took place before the moderation was not sustainable. As such, we believe that there is no cause for alarm. Poor corporate or macro data could constitute a further leg down, though these scenarios are fairly improbable. In all, while there is no cause for joy as of yet, the global economy has progressed from ‘bad’ to ‘less bad’, and that is progress indeed.

The UK has been slower than other major economies to pull out of the recession. While the country has recently seen a more rapid upturn as manufacturing has strengthened on the back of a weaker sterling and construction has rebounded. Growth has been only modest, however, and this recent flurry is unlikely to kick-start any meaningful capital spending. UK equities still appear relatively inexpensive and we expect that profits, rather than valuations, will drive returns in 2010.

As for the US, recent data have confirmed its tepid growth and the Federal Reserve has indicated that it will spearhead a second round of quantitative easing that might kick-start the economy more thoroughly through more state-funded cash injections. This stimulus, however, must be accompanied by real growth in order to succeed in the long term. As stated above, the US will probably not enter a double dip, but a continued slowdown is likely.

In Europe, sovereign debt worries, particularly among the peripheral countries, still persist, though somewhat alleviated by pledged support from the International Monetary Fund and the European Central Bank. Due to these persistent worries, Europe’s economic power house has relocated to the continent’s core as Germany has entered the largest period of growth since its reunification in the 1980s. The euro’s decline has boosted German competitiveness: the country’s production costs have not significantly increased and its exports out of the euro zone have become more attractive on the weakened currency. In addition, Germany has posted the 15th consecutive month of falling unemployment and the global recovering and strong manufacturing figures opens up job opportunities. That said, despite positive recovery figures coming out of Germany as well as France and Italy, the slowdown from the US and China will generally be a challenge to the region.

Furthermore, although the sovereign debt ratings of Portugal, Italy, Ireland, Greece and Spain have experienced some worrying downgrades, European companies continue to generate surprise earnings and most of the area’s major indices have delivered healthy returns of around 7%. There has also recently been a healthy pick-up in corporate mergers and acquisitions as companies look to take advantage of the affordable funding and attractive valuations presently available in Europe.

Growth in emerging markets remains resilient. The economic situation in these regions remains favourable as they have low levels of sovereign debt – unlike the West – as well as favourable demographics and a continued growth in consumer demand. As the global recovery has decelerated, there has been some monetary tightening in the emerging markets, but this may not have as much of a negative impact or be in place for as long as initially perceived.

Japan has posted a moderate increase in equity expectations but the contagion of the global slowdown in the West, particularly the US, remains as a risk to Japan as the country is highly trade-sensitive. Furthermore, investors have piled into the Yen as a safe-haven against the slowdown, subsequently weakening Japanese exports as the currency strengthens.

European Equities

In all, it is important to distinguish between the financial situation for European corporates and the economic situation for Europe. It is essential to remember that investors buy into corporate profits and balance sheets, not economies. That said, European equities experienced strong outflows in April and May, which is not particularly surprising given the region’s heightened sovereign debt concerns at that time. In comparison to other markets, European equity valuations are relatively inexpensive, and corporate valuations estimates for the year have retreated. That said, the region’s equities have begun to pick up as surprisingly strong company results continue. In fact, for the 2nd quarter of 2010, Europe had the most positive revisions for corporate growth among any of the developed markets on the back of strong autos and industrials growth. Merger and acquisition opportunities are returning as well, but universal confidence has not, as raising capital – especially from banks – remains difficult.

Growth trends in the euro zone are also changing, increasingly driven by companies in core markets with developing world exposure. As mentioned above, the region’s growth drivers have shifted back to the core from the periphery. Germany, for example, now accounts for 27% of the region’s gross domestic product, while Greece, Portugal, Ireland and Spain only account for a combined 15%, though there is significant scope to rebound.

One aspect that has made the market particularly challenging has been the strong correlation and low volatility between sectors and stocks – despite high volatility at the index level. This has made it difficult for stock pickers to add value, limiting the number of opportunities for strong performance. We believe this recent trend is temporary, though, and that picking will be increasingly rewarded over the course of the next couple of years. That said, European discretionary and luxury goods are poised to profit from the booming emerging markets, particularly in Asia, where the middle class’ appetite for conspicuous consumption is on the rise.

Despite this positive outlook for European equities, there are still some significant long-term hurdles to overcome. The aging population in the West is likely to stall growth, and some say it might even stop all together. Furthermore, the West has little-to-no consumer savings which will make it difficult to increase growth without stimulus from elsewhere, most likely developing markets.

Agriculture

Savvy investors should also keep a close eye on agriculture, as the sector -- and especially the grain outlook -- has experienced quite an interesting year. Droughts in Kazakhstan and Russia, as well as flooding in Canada slashed this year’s forecasted bumper crop of wheat to a net shortage. The market quickly learned not to count its sheaves before harvest, as initial forecasts became obsolete. Due to the drought, Russia imposed a ban on grain exports, which severely reduced expected global inventory levels, which were largely reliant on Russia’s crop. The sector was thus faced with the truth that in the event of a global shortage, the world would largely rely on a small handful of companies for supply.

Early planting in the US meant that the country’s wheat production this year was brought to an all-time high. But as wheat prices rise due to depleted global supply, farmers are increasingly planting wheat on acreages of land usually allocated for soy beans and corn. The inventory levels of these staples, however, are even tighter than wheat supplies. As such, the decreased corn and soy production has caused corn prices to sky-rocket and an upwards trend in soy is also expected. This ripple effect throughout the grain complex –beginning with a low wheat supply – is expected to continue into 2011. Any increase in next year’s wheat acreage will most likely be at the expense of corn and soy, which will stimulate further upsides in these crops.

Despite some rockier macro data in the global economy, the farming sector is in fact enjoying a more benign environment. Farming income this year is the third highest in a decade, and farmers are leveraged at less than 15% of their equity. Many farmers are also locking in this year’s elevated wheat prices for the coming winter and summer crops. This strong financial position will allow for re-investment in technology in order to increase yields or planting area.

Overall, there has been a sharp recovery in agricultural companies, especially those that are able to source wheat during this year’s shortfall. Companies providing input materials used maximise yields such as fertilisers stand to gain in the upcoming months as high grain prices drive farmers to reap bigger crops. These high prices will also give farmers an easy way to justify spending more on input materials for their crop. In this positive earnings environment, there has been a subsequent increase in mergers and acquisition activity such as BHP Billiton’s bid for Potash Corp. and Agrum’s bid for AWB. These cross-boarder transactions have show that the sector as a whole is fundamentally attractive in the long term and is not simply coasting on high grain prices.

All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority).