Quarter Ended 31 December 2010

The New Abnormal
Early in 2010 many questioned whether we would see a double dip recession or not?  While it was all a bit of a muddle, policymakers in the United States gave a good shot at rescuing the situation through quantitative easing.  While the world waits to measure whether this is succeeding, markets are caught between good results and prospects in the corporate sector and inconsistent macro economic developments.  As a result, equities, bonds, commodities and currency rates were extraordinarily volatile in the second half of 2010.

For example, global equity markets as measured by the MSCI World index were up by 18% in July, down by 8% in August and were up again, by 11%, in September.  The above is why Appian followed a cautious route in 2010 returning somewhere near 5% for our clients over the course of the year.

Most quoted companies around the world responded well to the recession by strengthening their balance sheets, cutting costs, shedding staff and improving margins.  Today, for example, UK companies have circa £140 billion of cash available on their balance sheets and some would argue that, if anything, companies are nearly overcapitalised.  They could resume or increase dividend payments or embark on mergers and acquisitions.  For the next 12 months alone our equities, which are generating a dividend yield of just under 3.5%, are due to grow their dividend payments by over 10% this year as measured by consensus forecasts.

However, this has to be finely balanced against leveraged governments and consumers - the United States will have a budget deficit of $1.6 trillion in 2010 while the average owed by every adult in the UK is 126% of annual average income.  Globally, the banking sector remains fragile, with banks holding enormous amounts of property loans of questionable value.

Emergency policy action has also been required in Europe where the European Central Bank together with the EU put together an emergency fund of €750 billion.  It is likely this will have to be raised to avoid euro weakness over 2011.

Taking all together, we see grounds to be cautiously optimistic on the corporate sector and consequently on equities, but there are plenty of concerns we continue to monitor very closely and we are prepared to respond swiftly if the outlook changes.  With the only certainty for investment markets for 2011 being that elevated volatility will again be a significant feature, we will continue to steer a cautious course during the year ahead. 

Global Macro Q4 2010
The continuation of quantitative easing (QE2) by the Federal Reserve in conjunction with better than expected macro economic data ensured that most asset classes benefited from a year-end rally.  Investors became less perturbed with regard the lack of US employment growth, a possible slowdown in Chinese credit growth and European sovereign risk as corporations continued to meet analysts' expectations on earnings. 

US Macro 2011
In conjunction with keeping interest rates at historically low levels the Federal Reserve extended its asset purchasing programme by $600 billion, expected to be completed by June 2011.  In addition the extension of the Bush tax cuts should provide a fiscal impetus for the United States economy.  These financial stimuli may provide a support to risk assets.  However, as always Appian is conscious of both the short-term and long-term risks. 

The most pressing short-term concern for Appian is the health of the United States consumer as they continue to de-leverage and increase their savings ratios to circa 6% of disposal income.  Unfortunately, other drivers of consumer confidence remain weak with a subdued property market and stubbornly high unemployment.  Our long-term concern is the deficit position of the United States.  While the US dollar and the US economy will continue to be perceived as a safe haven relative to the sovereign concerns emanating from the eurozone, we are fearful that there is a lack of political will to make the necessary but politically unpopular adjustments to the existing entitlement programs (social security and medicare).  This is particularly relevant as the "baby boomers" begin to retire.  As we have seen in the eurozone, the bond market may ultimately become the fiscal disciplinarian of the US imbalances. 

EU Macro 2011
The funding requirements of European banks and Governments will be at the forefront of investor concerns in 2011.  Greater political will is needed as the bond markets remain unconvinced by resuce efforts so far.  For Appian, political actions remain the driver in the short term regarding GDP growth in the eurozone.  A secondary concern is a possible slowdown in China and its emerging market peers which have been the driver of German export growth. 

UK Macro 2011
The inflation rate in the UK remains above 3%, with commentators questioning the credibility of inflation targeting by the Bank of England.  With VAT increasing to 20% and the commencement of the austere budgetary measures enacted by the governing coalition there is a possibility that the UK economy may experience 'stagflation light' i.e. a slowing economy with high inflation.  Such an economic scenario would not be beneficial for the UK domestic economy as it will become ever more reliant on exports to achieve GDP growth levels. 

Investment Markets 2011
Whilst equities may look undervalued relative to bonds, in absolute terms they trade at a premium to long-term historic average valuation multiples.  Form a short-term perspective, monetary and fiscal stimuli would suggest that equities remain relatively attractive.  We expect continued volatility in security markets with concerns focused on the continued de-leveraging at consumer and government level, direct and indirect manipulation of currencies as economies attempt to export their way to recovery and possible inflationary risks driven by continued commodity demand in emerging markets. 

In the sort term risk assets remain attractive.  However, the continued transfer of debt from the private to the public sector in developed countries will ensure that inflation or significant GDP growth may be needed to eradicate such significant liabilities. 

Syngenta
Swiss agri-chemical producer Syngenta was a strong performer within our equity portfolio in Q4, gaining 12%.  Its performance was constrained in the previous six months as a build-up of excess inventories in its markets led to price discounting.  Its crop protection and seeds products are now expected to experience better market conditions reflecting (i) stronger demand as drought damage reduced crop output in 2010, boosting soft commodity prices, and (ii) a more favourable pricing market given 2010's inventory overhang has cleared. 

IBM
With a 9% share price rise in Q4, IBM was another to catch the eye among our equity holdings.  The company has benefited from recovering corporate I.T. spending through 2010, but in Q4 it was improving prospects for its services business that pleased investors.  With recovery in this division lagging the rest of the group, the improving outlook here reassured the market that this was a timing issue and not an indication of a more fundamental problem for IBM's services business.

Humana
The main addition to equity portfolios in Q4 was Humana, a leading US provider of healthcare plans and insurance, replacing Centrica which was sold late in Q3.  Humana is expected to be a beneficiary of the US healthcare reforms initiated last year, allowing it to increase member numbers by increasing its penetration of the market.  This, together with the opportunity to deploy the net cash on its balance sheet in complementary acquisitions underpins prospects for good profit growth over the medium term.  We considered this outlook and a valuation of less than ten times earnings attractive. 

John Mattimoe
Senior Portfolio Manager
January 2011