The US dollar continued to decline versus major currencies as a result of expectations of a weakening economy and further Fed rate cuts.
By AARON LEITNERmerryl liynch image 88 2(photo credit: Bloomberg)Equities Markets
October's equity markets witnessed many indexes reaching new highs. The MSCI AC World recuperated most of its losses from this summer's declines as did most major equity indexes.
In the US, the September Fed rate cut accompanied by expectations of an additional rate cut, positive earnings reports, an improving trade deficit, a surprisingly strong Q3 GDP report and low unemployment numbers provided fuel for the markets. Towards the end of the month, reports of multi-billion dollar sub prime mortgage related write downs by major investment banks including Merrill Lynch and Citigroup accompanied by continued increases in fuel and gasoline prices, as well as reports indicating a continued decline in housing prices and sales, rattled the financial markets, precipitating steep declines.
Once again investors fled to safer asset classes causing an outflow of funds from lower grade debt and emerging markets equities. The VIX has once again reached record highs as investor uncertainty continues to perpetuate a nervous market environment. We can expect to see continued mood swings (translation; market surges and declines) for at least several more weeks. I recommend reduced exposure to the financial sector while increasing exposure to export oriented companies.
Large Cap US growth equities continue to trade at attractive P/E's hovering around 20. The weakened US dollar will continue to contribute to GDP growth and a reduced trade deficit. Since before the summer, it has been my view that the US housing market will only see recovery toward the end of the first half of 2008. Recent data released has not changed this view. The lynchpin is still the unemployment numbers. Currently, it appears that unemployment is in an acceptable range to allow for continued, albeit modest, economic growth. With interest rates at a low level and likely to be reduced at least 0.25bps further, US equities still remain attractive.
In Europe, economic indicators suggest that a more pronounced economic slowdown will not start to manifest itself for at least several more months; though first signs seem to be reflected in various economic reports. Am ECB rate cut would not be a surprise during the first half of 2008.
Corporate Europe is more exposed to an erosion of revenues due to a high euro. The real estate market in the UK reported a surge in housing prices, but this may only be a blip on the radar screen as the UK experiences a continued softening of its housing market and a ripple effect on its economy; further aversely impacted by a strong GBP. European/UK equities should be underweighted to US large caps. Japan's declining wages, increasing unemployment, reduced consumer spending and other economic indicators suggest that its economy remains rudderless and not likely to grow significantly over the next 12 months. Japan should be underweighted; maintaining an exposure to large cap internationals with less dependency on the local market. Both Canada's and Australia's markets continue to remain attractive, supported by strong commodities markets.
Emerging markets fundamentals remain attractive as Asian and Latin American countries continue to exhibit overall strong economic fundamentals. The Chinese and Indian governments have taken steps to cool down their economies a bit. China's third quarter GDP growth of 11 percent reinforces expectations that China's insatiable appetite for various commodities will continue unabated. The short term major issue regarding emerging market equity markets appears to be one of foreign investor sentiment; which is proving to be fairly erratic at the moment.
Fixed Income
Emerging market debt was the big winner for October as investor appetite for risk, in fixed income assets, demonstrated a clear preference for reduced exposure to high yield US and European debt. I am continuing to maintain significant exposure to emerging market debt, both local and hard currency. For higher quality debt, look also to invest in 2-5 year maturities, focusing on Canadian dollar, Eurobonds, Australian dollar bonds and US dollar bonds.
Currencies
The US dollar continued to decline versus major currencies as a result of expectations of a weakening economy and further Fed rate cuts. The USD was also under pressure as a result of the Chinese government's announcement of its intentions to reduce its USD reserves and indications that other central banks were shifting form the USD to the euro. The Canadian dollar continued to reach new highs as did the Australian dollar. The yen weakened as expectations of a Bank of Japan rate hike faded and carry trade activity increased. Though I believe that the USD is fundamentally undervalued, it is likely to remain under pressure through the remainder of 2007. A turn around is more likely towards the later part of the first half of 2008. The British pound is likely to weaken over the next few months as the Bank of England is likely to implement a rate cut.
Gold continued to strengthen due to increased jewelry demand from the Asian sub continent, a weakened USD and flight to safety over volatile market conditions and concerns over a deteriorating situation for the US economy. Oil moved up on a weakening USD and reduced global output. Currently I see no abatement in the up trend for both gold and oil. It is interesting to note that higher energy prices contribute to increased US oil production.
Hedge funds, overall, performed well in October. Long/Short managers are continuing to find attractive investment opportunities on the long and short side of the portfolio. A strong market rebound has provided enhanced returns to net long positions. Opportunities will continue for global managers, though Japan remains unattractive. Multi-Strategy funds will tend to benefit in the current global market environment being able to shift weightings in outperforming strategies. Capital Structure/Credit Arbitrage should benefit from higher levels of market activity and credit spread volatility.
aleitner@tandem-capital.com
The author is a global investment strategist at Tandem Capital
Yulia Vaiman, a Macro Research Analyst at Tandem Capital, contributed to this report
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