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Low-risk assets could offer attractive returns in 2009, says Merrill’s Dugan

Low risk assets could offer private investors the best prospects of attractive returns in 2009 as the world’s leading industrialised nations face recession, according to Gary Dugan, the

Low risk assets could offer private investors the best prospects of attractive returns in 2009 as the world’s leading industrialised nations face recession, according to Gary Dugan, the author of Merrill Lynch Global Wealth Management’s Year Ahead 2009.

However, he says hedge funds should be treated with caution.

Dugan, chief investment officer of Merrill Lynch Global Wealth Management in Europe, the Middle East and Africa, says that with governments around the world striving to tackle the economic crisis, private investors could find value in a cautious approach towards asset allocation.

Options include high-grade corporate bonds and high-quality, high-yielding equities in defensive industries.

Dugan says governments are expected to play a pivotal role in tackling the economic crisis, using tax cuts and public spending to spur growth. Governments will have to strike a delicate balance between promoting growth through public spending and resorting to excessive borrowing.

‘It’s going to be a decisive year for the world economy,’ he says. ‘Government intervention will play a critical role in determining whether we experience a relatively short and sharp downturn – which could draw to a close within the next 12 months – or a long and lingering recession such as that experienced in Japan in the 1990s.’

Governments may have to consider significant fiscal packages worth between two and five per cent of gross domestic product to help kick-start their economies and boost flagging consumer and business confidence, according to Dugan.
 
‘Investors will look to long-term US government bonds as an important barometer of the progress of global recovery. Sharply rising bond yields will show that the governments have overspent.’
 
The policy response of governments globally to the crisis, however, could prove decisive in determining the length and severity of the downturn.

‘Policy makers will have to offer effective fiscal packages to stimulate their economies,’ says Dugan. ‘The seeds of recovery could be sown in 2009 but if they fail to germinate we could face a multi-year recession.’

In addition to a continued unwinding of high levels of borrowing and further profit warnings, deflation could emerge as a major theme in 2009.

‘The risk of deflation is greater than many people expected,’ Dugan adds. ‘We think there is a low probability of persistent deflation but it would have a major detrimental impact. Monetary policy will need to remain aggressive and innovative to counter the threat.’
 
While earnings downgrades are likely to dominate the first quarter of 2009, a rally in global equity markets could be on the cards for the first half of the year with consumer and cyclical stocks among the potential beneficiaries. Broad equities indices could also offer trading opportunities to private investors in 2009.
 
‘Equities could outperform as an asset class in 2009 unless there is a serious deflation risk,’ says Dugan. ‘Our view is that deflation will be avoided. Government action to stimulate economic growth and central bank interest rate cuts could fuel a rally on global equity markets in the first half of 2009.’
 
He adds that investors should remain cautious: ‘They need to be prepared to take profits. We think any such rally would run out of steam by the second half of the year.’
 
While commodity markets could also bounce back in the first half of the year, a rebound is likely to be short-lived in the absence of strong US consumer demand.

Dugan believes precious metals, led by gold, could enjoy a more sustained rally with gold benefiting from a weakening of the dollar in the second half of the year.

He also says selective investment in high-grade corporate bonds could provide attractive returns.

But high-yield and emerging markets debt is likely to remain unattractive with risks of emerging markets undergoing a strong reassessment as developing economies – including the US, UK and Canada – face recession in 2009.

Investors could also look to private equity, Dugan says, which produced strong returns in the downturns in 1991 and 2001, on an opportunistic basis.

Some hedge fund strategies may be worth following but hedge funds should be treated with caution as an asset class in its own right, according to Dugan.

While the dollar has returned to fair value, sterling is expected to remain under pressure against the dollar in the first half of 2009 amid fears of a protracted recession in the UK. But Dugan says sterling could stage a recovery by the second half of the year.
 
Currencies of emerging markets like Russia, Brazil and South Africa could face added pressure because of their sensitivity to commodity prices.

‘A potential run on emerging market currencies remains a concern,’ says Dugan. ‘Emerging markets are expected to under perform even in a rally due to concerns about the long-term prospects for sustained growth, such as inflation and tightness of credit.’
 
He adds that with interest rates in some economies heading towards zero, a return of consumer confidence will be vital to reignite economic growth: ‘In addition to interest rate cuts and government spending, consumers will need to feel their jobs are safe in order to feel confident about spending money.’

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