Investor strategy: A new bull market?

The US Federal Reserve surprised markets on Tuesday by cutting its main interest rate half a percentage point to 4.75 per cent, with most people expecting a reduction of a quarter point.

The Fed’s move to ease tensions has bolstered sentiment but will the rate cut result in a new bull market? Graham Secker, chief UK equity strategist at Morgan Stanley, answers your questions.

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The question is simply, will the Fed cut in interest rates create a bull market?
John Robinson, Pontefract, UK

Graham Secker: We believe that the Fed’s early and aggressive rate cut will be able to reflate the US economy, particularly in light of strong growth from other areas of the world such as Asia. Therefore, the chances are good that the extra liquidity provided by this latest rate cut does indeed prompt a continuation of the bull market that started in 2003.

From here the biggest beneficiaries in this bull market are likely to be companies with emerging market exposure as this is where the best growth is coming from.

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Given the turmoil in the credit and equity markets, do you think investors are wise to get out of all sorts of credit and equity investments? Also, with a property downturn predicted in the UK, are there any asset classes where returns of 10-20 per cent can be achieved?
Anon, London

Graham Secker: We believe the worst of the turmoil is now behind us and are encouraging investors to move back into equities as we believe that the Fed’s decision to cut rates will help stabilise the US economy.

Credit assets in general are likely to face a tougher time ahead having performed so strongly over the last few years, spreads are likely to widen and returns are likely to be modest at best. The only major asset class that has a good chance of making 10-20 per cent over the next year or so is equities - unless we do see a full blown economic recession that drives bond yields sharply lower.

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Does Fed is trying to delay the inevitable and in fact the the rate cut of 50 bps will fuel problem further?
Dinesh Talreja, Mumbai

The Fed is trying to prevent the US economy weakening too quickly rather than reignite risk taking and easy lending - if we see signs of the US economy improving then we’d look for Bernanke to be much quicker than Greenspan in raising rates again.

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Do you not think that the current price of 10yr. gilts factors will be a significant setback to the economy in the next few years, when we could be on the brink of one now with the credit crisis?
John Le sage, Dulwich London

Graham Secker: We are more cautious on the outlook for the UK economy than most - certainly with regard to the Bank of England and the Treasury.

The UK consumer’s debt burden is likely to prove a significant drag on economic growth over the next couple of years, however this is likely to result in a protracted period of below trend economic growth rather than something worse such as a recession.

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Over the past couple of years, small and mid-cap companies have had a strong performance across Europe. Over the next year or two, do you see this trend continuing or large cap stocks outperforming?
James, Edinburgh

Graham Secker: Large-cap stocks should outperform the wider market over the next few years - they are cheaper, have stronger and safer balance sheets and would be big beneficiaries of liquidity flows from sovereign wealth funds from the likes of China, Middle East, etc.

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Do you think that all the bad news of the subprime issues in the US have been discounted in the market and more bad news would not initiate a pullback as substantial as the one in August?
Thuc To, Riga, Latvia

Graham Secker: Yes - the market has had a lot of bad news thrown at it in recent months and we would need to see the news get even worse for the market to suffer a significant pullback - this is unlikely unless the US economy really is heading into recession.

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Conditions of the currency market reminds me of the fall in the US dollar’s value in the 1990s. Although the prospects for a recovery were then better than they are today, and with the US currency falling to 25 years lows and interest rate cuts while inflation is rising, what would you advise is in order to save the capital?
Gil Miles, US

Graham Secker: The outlook for the US dollar does not look particularly rosy however it is in no one’s interest to allow the dollar to fall too quickly - an orderly decline in the currency should have a modest impact on financial markets but no worse than that. Eventually, we will need to see Chinese currency revaluation to restore a long-term equilibrium within FX markets.

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If the US enters a recession does it still follow that Europe and/or Eastern Europe will be affected in turn? Strategically could one avoid most of the risk by liquidating US dollar investments and investing in, the rouble or other East European stocks?
Jim Bateman, Nr Laval, France

Graham Secker: The extent of any contagion would depend on how much the US economy slows - a full blown US recession will also hurt the global growth outlook and the US dollar will probably outperform due to its ’safe haven’ status. A modest US economic slowdown however will not slow the global outlook too much and will probably cause the dollar to weaken further. We are in the latter camp and expect emerging european economies and stockmarkets to outperform.

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Is it fair to conclude that the the liquidity/credit crunch is US specific and emerging markets could continue to see a bull run in the near future?
Srihari Adiga, Bangalore, India

Graham Secker: The current liquidity/credit crisis is primarily relevant for the US economy and financial markets more generally. The knock on impact to emerging market growth should be modest provided that the US economy doesn’t fall into recession.

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How long before the current derivatives accounting magic (bank’s Level III assets) dissolves into panic and blame? Several more Bernanke fuelled short-squeezes aside, the US equity markets are poised to reaquaint themselves with a bitter reality: 1970s style stagflation. Discuss.
J. Bridges, Chicago

Graham Secker: Stagflation is indeed a risk, however it is certainly not a most likely outcome. Economic growth should continue to be strong outside of the Anglo-Saxon economies for the next couple of years and inflation is unlikely to accelerate markedly from here without a wage-price spiral - which is unlikely given the growing global labour force and subsequent weak pricing power of the western workforce.

We suspect that derivatives are here to stay - the recent downturn isn’t severe enough to bring this area of financial innovation into question.

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Is this a mere housing crisis or mortgage crisis or a disintegration of the entire global financial system? how do we stop the income drain on the population, brought on by the hyper-inflationary debt bubbles created by Alan Greenspan?
Mathilde, London

Throughout history every Fed tightening cycle ultimately leads to a financial crises of some description - this is what we have seen over the past few months as the US sub-prime issue unwinds. Financial crises usually end with some form of authority intervention - this is what we have seen in the last few weeks from various central banks.

It would be a brave man to bet against the Fed or the robustness of the global financial system (”Don’t Fight the Fed” has proved to be very sage advice over the years). At this juncture the biggest risk to the consumer-oriented economies comes from falling employment rather than higher rates - the risk on the former wont come until we see a severe slowdown across the entire global economy.

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Has the Fed’s recent cut in interest rates succeeded in restoring calm to an otherwise turbulent summer in the markets? If it has, would you still be long in equities and which geographical area? If not, what steps would still be needed before calm is restored?
Peter Koh, Rome

Graham Secker: Money and credit markets have continued to improve post last week’s Fed rate cut so it does look like the medicine is working - therefore we would remain overweight equities and recommend investing within emerging markets.

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Now that the Fed has caved in to the pressure from geared investors and lowered interest rates, what strategy would you suggest to avoid inflation in a mixed US/European portfolio?
Svensson

Graham Secker: The best performing asset classes in periods of high/rising inflation have historically been equities and real estate. Given the massive rise in the latter (and record high valuations) we would be reluctant to invest in property here so equities are likely to provide the best protection from inflation.

After equities, commodities should also hold up relatively well. Investors who are afraid of rising inflation should sell bonds - once you adjust for inflation the real return in gilts over the last 70 years has been negative.

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Isn’t the interest cut simply delaying the inevitable and making the eventual deflation of the asset bubble even harder than it needs to be?
Borzou Aram, London

Graham Secker: One day this economic cycle will end and the ending is likely to be very messy given the amount of debt within the financial system and particularly with regard to western consumers .

Whatever your view on “moral hazard” the latest rate cut does delay the ending, however, and is likely to prolong this cycle for another couple of years - the last stages of the economic cycle tend to produce strong returns for equity investors so we think it is too early to sell today.

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How likely is it over the next 12 months that large cap stocks in developed markets will outperform their small cap counterparts? Would you agree with Jeremy Granthams recently reported suggestion that one way to ride out the coming storm would be to short the Russell 2000small cap index and go long the SP 500?
Stephen Piercy, South Korea

Graham Secker: I would fully agree with Jeremy’s positive view on large-caps - they offer the best value and have the strongest and safest balance sheets. Liquidity and asset allocation factors become increasingly important in the latter stages of a bull market - this is where we think we are now - and large-caps are usually the biggest beneficiaries of such liquidity inflows. The biggest valuation differential between large and mid/small caps is available in the UK due to the continued pension fund selling.

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Where is the best place for a casual investor, with say half a million pounds, to put their money?
Mark, Harrogate

Graham Secker: A very nice problem to have! Individual investors should always look to maintain a balanced portfolio of investments (ie a mix of cash, bonds and equities) - assuming you already have this then I would recommend putting new money into equities. Again you should spread your equity investment around so I would split your investment between emerging markets (where there are good opportunities for growth) and large-cap stocks in developed markets (which offer good value and pay out a decent dividend yield).

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Do you think equity markets now represent good “value”?
Pol, Ireland

Graham Secker: Yes I do think equities look good value here - they are by no means bargain basement cheap but they offer the best value of any other major asset class. Note that the UK stockmarket trades on a PE of 13 - this is the lowest level since 1991 when 10-year gilt yields were 10 per cent versus 5 per cent today.

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What will be the main implication on investment banking if the ECB follows the Fed and cut rates?
Emilia Taylor, London

Graham Secker: The implications for investment banking of an ECB rate cut very much depends on the circumstances behind it. An early rate cut to bolster the growth outlook and smooth money and credit markets should boost confidence and benefit investment banking substantially. However if the rate cut were a response to a sharp deterioration in the growth outlook then the opposite would apply.

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Does Fed is trying to delay the inevitable and in fact the the rate cut of 50 bps will fuel problem further?
Dinesh Talreja, Mumbai

The Fed is trying to prevent the US economy weakening too quickly rather than reignite risk taking and easy lending - if we see signs of the US economy improving then we’d look for Bernanke to be much quicker than Greenspan in raising rates again.

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About the expert

Mr Secker has been chief UK equity strategist at Morgan Stanley for 5 years. He is also a member of Morgan Stanley’s European strategy team that was voted nu,ber one in the latest Extel survey. Previously, Mr Secker worked in the equity strategy team at UBS from 1997 to 2000.

Having been cautious on equities for much of this year the Morgan Stanley’s strategy team upgraded their view to overweight in mid-August and are optimistic that stocks can make good progress over the coming months.