Market commentary

October 2009

Economic overview

While economic conditions have clearly improved since the beginning of the year, there is growing concern over equity prices, and whether they have overshot corporate earnings and the fundamental value of companies. Equity markets have rallied strongly this year on the confirmation of recovery in both developed and emerging markets. However, the risk to economic growth in developed markets appears to be on the downside as employment conditions remain weak and consumer demand continues to be lethargic. This risk can perhaps be best illustrated by the decline in the UK's third quarter GDP, which fell unexpectedly by 0.4 per cent quarter-on-quarter versus consensus expectation of 0.2 per cent growth. The inevitable withdrawal of government stimulus measures is a further risk to growth as markets have been riding on liquidity, and economic recovery has been driven by loose monetary conditions. At a regional level, Latin American equities have the potential to outperform emerging Asia. The positive news flow in Latin America coupled with the still highly attractive Price/Earnings discount to emerging Asia are supportive of this view. The rebound in commodity prices and the strong demand for resources in Asia add further support to Latin America equities relative to emerging Asia.

UK

The Consensus estimate for UK Gross Domestic Product growth in 2010 was revised up to 1.3 per cent (+0.2 per cent) in October, while the forecast for 2009 growth was unchanged, at -4.3 per cent. Economic data released during October were generally disappointing. UK GDP unexpectedly declined by -0.4 per cent quarter-on-quarter in the third quarter. Consensus Economics had forecasted a 0.2 per cent quarter-on-quarter increase in the third quarter. Industrial production also surprised on the downside, falling 2.5 per cent month-on-month in August. Of additional importance, consumption was not strong either with the households' savings ratio climbing to 5.6 per cent in the second quarter from 3.6 per cent in the first and month-on-month retail sales flat during September. Unemployment remains a key factor in the low levels of consumption. In September, the claimant count rate rose to 5.0 per cent, from 4.9 per cent a month earlier. On a more positive note, house prices improved. Nationwide data showed that house prices were flat relative to a year ago in September, against a 2.7 per cent drop in August. Turning to inflation, prices fell to 1.1 per cent year-on-year in September, more than expected by consensus, against 1.6 per cent year-on-year in August.

Gilts (inc. Index-Linked Gilts)

While risk appetite in the UK remained strong for the first half of October, investor's confidence waned towards the end of the month as a weaker than expected third quarter GDP result shook confidence in the sustainability of the economic recovery. Yields continued to be suppressed, through the quantitative easing (QE) programme, coupled with aggressive monetary and fiscal stimulus measures. There was also increased nervousness about the timing of any withdrawal from government stimulus plans, as well as possible tightening of fiscal and monetary policy. Government bonds managed flat performance of -0.27 per cent during the period. During the month the Bank of England maintained interest rates at 0.5 per cent and did not extend the QE Programme beyond the USD175 billion already reached. CPI inflation came in lower than the market expected , coming in flat on the month to 1.1 per cent year-on-year, down from 21.6 per cent year-on-year in August.

Global Bonds

US government bonds fell in October for the first time in four months, ending the month slightly down by 0.06 per cent, bringing the year-to-date losses for US Treasuries to -2.51 per cent. While risk appetite remained strong for the first half of October, confidence waned towards the end of the month as investors became increasingly nervous about the sustainability of economic recovery and the timing of any withdrawal from government stimulus plans, as well as possible tightening of fiscal and monetary policy. Two-year Treasury note yields rose above 1 per cent mid month, amid speculation that the Federal Reserve may begin to signal a rise in interest rates at the upcoming policy meeting in early November. Governments have managed to keep yields suppressed, through quantitative easing, coupled with other monetary and fiscal stimulus measures. Once these measures end and fixed income investors start to focus on the full extent of government liabilities, yields are likely to be forced much higher. Eurozone government bond prices were broadly close to flat in October, in the face of mixed economic data for the region. The asset class posted slightly positive returns of 0.13 per cent for the month as a whole. Yield levels were little changed since September with a very slight upward shift of the curve and the 10yr yield increasing from 3.22 per cent on 30 September to 3.23 per cent on 31 October. The slope of the yield curve was also little changed over the month. The Consensus Economics forecast for consumption growth in the Eurozone unchanged for 2009 at - 0.9 per cent and expected to increase slightly in 2010 to 0.3 per cent. The European Central Bank left policy rates unchanged at 1.0 per cent at its November meeting. ECB President Trichet noted that the economic newsflow continued to "signal an improvement in economic activity".

Currencies

The UK's deteriorating public sector finances and decline in third quarter GDP are negative for the currency. While inflation in the UK has receded to below the government target, the Bank of England noted in August that the country's CPI remained 'surprisingly high'. As such, this is a further reason to be negative on the GBP as inflation would affect the real yield on UK assets. As such, structural and cyclical weakness of the UK coupled with unattractive real yield support our view of a weaker GBP relative to EUR.

Europe

European equities had a tough month in October amid speculation that the recent rally had outpaced prospects for economic growth. The MSCI Europe index fell 2.7 per cent. Investors displayed concern following mixed corporate newsflow. In Europe ArcelorMittal missed consensus earnings estimates. On the economic front, Eurozone GDP was down 0.2 per cent quarter-on-quarter in the third quarter, which was below consensus estimates. The PMI index in the Eurozone rose above consensus estimates to 50.7 in September, indicating an expansion in manufacturing activity from a month ago. Of additional importance, was the further fall in Germany's unemployment rate, to 8.1 per cent in September, leading Germany's Bundesbank President Weber to start talking about the withdrawal of stimulus. The weak economic growth figures for both the Eurozone and the UK serve as a timely reminder that the level of economic activity is still fragile. The negative tone of some earnings results, particularly underlying sales forecasts is a warning that we still face headwinds to any sustainable economic recovery, especially as the level of economic support is likely to ease in the short term. Following an impressive rally in European equities and elsewhere, there is a growing concern that current prices continue to reflect an overly optimistic level of future growth for 2010, especially if not supported by further improvement in economic data.

US

The recent optimism regarding the outlook for economic growth somewhat eroded in October, leading US equity markets to lose ground. Economic readings were not disappointing though and continued to indicate that the US economy was recovering. For example, US GDP growth turned positive in the third quarter, topping the consensus estimate, at 3.5 per cent quarter-on-quarter. However, some data spurred concern amongst investors, especially personal spending, which dropped 0.5 per cent month-on-month in September and unemployment reached a 26-year high, at 9.8 per cent. On the corporate front, earnings were also encouraging, with so far more than 82 per cent of companies in the S&P500 Index reporting better than - expected earnings during the third quarter. That said, the year-on-year growth in sales is still below -10 per cent, indicating that top line growth is still weak. In fact, the positive releases failed to mitigate investors' nervousness regarding the impact of a potential shift in the monetary and fiscal stimulus in the US. Following a 7-month rally in equities, it seems that equity prices may have outrun the improvement in macro economic fundamentals. We believe that the risk for a correction has increased, especially if economic and earnings data disappoint in the short-term.

Japan

Japanese equities were down 1.4 per cent in October, dragged by the weak performance of financial stocks and a strong Yen which has put pressure on exporters. In addition, there was more uncertainty regarding the impact of government and central bank decisions on economic growth, which led to some nervousness from investors at this early stage of the recovery cycle. Half-year earnings reports were encouraging in Japan, with more than 50 per cent of companies in the Nikkei 225 beating consensus estimates so far. However, earnings are still down more than 40 per cent from a year earlier in aggregate. Furthermore, with the possibility of early reductions in fiscal and monetary support increasing, the risks regarding the level of consumer demand and future corporate profit, are now higher. Given the optimistic estimates for earnings growth in 2010, we think there is a risk for some negative earnings surprises, if the forecasts are not supported with improvements in final demand.

Asia ex Japan

Asia-ex Japan equities declined overall in October (-0.7 per cent). Some disappointing earnings releases towards the end of the month were a key contributor to investors' nervous mood, fuelling concerns that equity prices may have run ahead of economic fundamentals. For example, Canon, the world’s largest camera maker reported its seventh straight drop in quarterly earnings. However, some markets within the region posted strong returns such as China, up 6.5 per cent. On the economic front, the region continued to show strong improvements. For example, Korea's GDP expanded at the fastest pace since 2002, 2.9 per cent quarter-on-quarter in the third quarter, whilst China's GDP growth stood at 8.9 per cent for the third quarter. With more evidence that Asia's economies are strengthening, the chance that central bankers could begin raising rates in coming months has increased. In Australia, the RBA led the way increasing its reference rate by 25 bps in both October and November, bringing the rate to 3.5 per cent, on concerns regarding medium term inflation. In addition, in India, the RBI tightened non-performing asset norms for banks and may consider a hike in its reference rate after revising its inflation target for 2010 to 6.5 per cent.

Emerging markets

Global emerging market equities were down 0.4 per cent in October, but showed mixed performance at the regional level. Emerging Asia was down 1.1 per cent, Latin America down 0.4 per cent and Eastern Europe up 2.2 per cent, boosted by a weaker dollar and rising oil prices (+9.1 per cent). On the economic front, the markets' volatile reactions to US economic data releases provided ongoing evidence of investors' nervous disposition. Emerging equities corrected sharply after new home sales unexpectedly fell in September, and rallied later in the month, as third-quarter GDP growth in the US surprised on the upside. Within the region, economic activity improved further, underlining the likelihood that EM countries will drive global economic growth in 2010. In the headlines was Brazil's 2 per cent tax on new foreign inflows into both fixed income and equity markets. The move, which led to some volatility in equity markets, was a signal regarding the rising concerns about excessive inflows into EM markets and more particularly their impact on currencies.

Oil, gas and gold

The oil price posted a further month of gains, with the WTI spot price gaining over 9 per cent, moving from USD 70.61 p/b at the end of September, to USD 77.0 on 30 October. The price increase was driven primarily by weakness in the US dollar and continued positive investor sentiment for most of the month, with the oil price reaching an intra-month high of USD 81.04 on 21 October. Towards the end of the month, the oil price fell, after the US Department of Energy reported unexpected increase in gasoline stockpiles and crude supplies rose to a two-month high. In addition, some disappointing data releases towards the end of the month, dampened demand for riskier assets, further weakening the oil price. Natural Gas markets also showed a strong gain, rising 25.6 per cent during the month as the build-up to winter begins. Base and precious metals continued to show strong growth on the back of an improving outlook for economic growth. Copper rose 5.01 per cent, while gold played a role as the safe-haven and attracted investors away from the US Dollar to gain 3.74 per cent during the month.

All figures, source: Bloomberg, total return in sterling terms unless otherwise stated.

For professional advisers only and not for distribution to retail clients. The views expressed are those of HSBC Global Asset Management and do not constitute investment advice. No liability is accepted to recipients acting independently on its content. Information has been obtained from sources HSBC Global Asset Management (UK) Limited believes to be reliable but which it has not independently verified. The value of investments and income from them can go down as well as up. Past performance refers to the past and is not a guide to future returns. Changes in rates of currency exchange, particularly where overseas securities are held, may also affect the value of your investment. Investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in established markets. All rights reserved. Issued in the UK by HSBC Global Asset Management (UK) Limited
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