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Are consumers too pessimistic… or investors too optimistic?

Lately we have seen a few market developments which appear to be inconsistent with one another. Equity markets have rallied strongly, but consumer confidence has fallen. Fear of inflation has been broad based, but bond yields have been declining. Risk appetite has been rising, but private investors still prefer to park their money in low yielding saving accounts.

What should we make of all this?

The recent rise in equity markets can be explained by the combination of a stabilising US economy with better than expected corporate earnings.

Unlike consumers, investors are programmed to start playing the Great Recovery Game as soon as the economy stops getting worse. Lately, this conditioning was reinforced by central banks telling us that rates will remain lower for longer and companies telling us that earnings have fallen less than feared.

Conversely, consumer behaviour is primarily dependant on the health of the housing market and the availability of jobs. They see less reason for joy, which is quite understandable after the biggest drop in house prices in 80 years and the biggest rise in unemployment in 30 years (in the US).

In the slipstream of the largest debt accumulation in history, consumers as well as companies now need to reduce debt. Companies have tackled this issue more enthusiastically than ever before, partly by reducing the size of their workforce at record speed. Indeed, the aggressive nature and broad based implementation of cost cutting measures has been the main reason for the better than expected earnings. Households are also reducing debt. Pressured by job losses, lack of real wage growth and declining house prices they have started to save, a behaviour they are not likely to change any time soon.

In short, we think that both the optimistic investors and cautious consumers are acting rational in the context of their own position.

On the issue of inflation, many still fear that rising government debt and continued “money printing” will lead to higher prices in the future. Even though this cannot be ruled in the more distant future, it appears that the deflationary pressures caused by high overcapacity and high unemployment will be more important in 2009 and maybe even in 2010. Besides this, for the longer term we should not forget that the aging society in the developed world is also a phenomenon which is likely to keep inflation subdued, as can be seen in Japan.

As for equities, the rally may be extended even a bit further, based on growing earnings optimism for the future. However, at some time in the next 6 to 9 months the positive impulse on earnings of cost cutting and restocking will have to be followed by a positive impulse from accelerating consumer spending. That may still prove to be difficult. We do not think that in 2010/11 we will see the

same V-shaped earnings recovery as in 2004/5. The 2004 recovery started from clearly lower margins and took place in an environment where consumers had lower debt, more jobs, higher wage growth and increasing housing prices. We do therefore not expect this pattern to be repeated now. Yes, earnings will rise, but only at a modest pace.

At the moment, we still like government bonds and high quality corporate bonds as alternatives for low yielding saving accounts. In equities, we slightly prefer defensive sectors with high divided yields (telecoms, pharma, utilities, energy). In a balanced portfolio, we still like emerging markets and US technology shares as long term growth themes.