The rally in equity markets off their recent lows has reinforced our view that we remain in a consolidation phase. We are now 12 months on from the turn in the markets as the potential financial crisis was averted and the domestic economy started its recovery. The market has re-rated back to its long-term valuation, contingent on a recovery in earnings of 20% in the 2011 financial year. It is the confidence in this earnings recovery which will drive the markets from here.

The key swing factors relate to the US and Chinese economies. During March there were favourable developments on both these fronts. In the US the signs are beginning to emerge that employment is improving, following a lull over the northern winter. We believe that we will see a short term step up in US activity, however we are concerned that this will be relatively short lived given the continued structural issues relating to debt in both households and at the government level. In China we got a clear message from policy makers that they will not aggressively tighten policy, reflecting their concerns about the uncertainty of the global economic environment. Our recent trip to China highlighted that underlying infrastructure investment is continuing, with the projects started last year providing plenty of work to continue growth through this year. In addition, we anticipate a pick up in property investment as the government seeks to increase supply to deal with the rise in prices. The economy will start to slow later in the year, but the policy mistakes of 2008, when the Chinese over tightened are fresh in their mind, and will lead them to err towards growth.

The domestic economy is transitioning from being driven by government stimulus and the consumer towards growth coming from investment, particularly relating to the resource sector. The terms of trade shock will generate substantial growth in the second half and in addition continued strong population growth will underpin the economy.

The February reporting season provided a direct insight into corporate performance. The sharp reactions to announcements, in both directions, highlight that at the current time the market is close to fair value and relying on a strong earnings recovery. Any signs of a delay in this are dealt with harshly by the market, however this is providing opportunities to buy into good longer-term stories that the market has lost patience with. Reporting season confirmed that the recovery in the domestic economy is flowing through, with the banks in particular benefiting from a drop off in loan losses. Overall the continued improvement in balance sheets helps to reduce the risks from any future economic shocks and would suggest that M&A activity will become a bigger theme in months to come.

In this environment, the portfolio’s key exposures are to the resource sector, but rather than concentrate that solely in mining stocks it is spread across a number of themes being bulks, energy and engineering services, covering companies such as Rio, Oil Search, Worley and United Group. In addition we are exposed to the ‘back end’ of the domestic economy, i.e. companies exposed to greater corporate spend in the supply chain such as Qantas and Asciano. Finally, we are cautious for the near term on consumer-sensitive stocks as we see the effects of rising interest rates kick in.

Crispin Murray
Head of Equity Strategies
BT Investment Management