Investment Review and Outlook Apr 2009

by Andrew Newman
in Economy
28 May 2009 | 0 Comments

Rallies abound, yet structural headwinds continue

The rally in risk assets from the lows reached in early March has been unrelenting and apparently impervious to any new bearish developments such as the ongoing travails in the financial sector, the possibility of a flu pandemic, and looming bankruptcies in the auto sector.

This rally is different to the previous rallies during this punishing bear market as it has been supported by a substantial improvement in the leading indicators of economic activity in all global economies. The collapse of Lehman's led to a synchronised downturn in activity followed more recently by an equally synchronised improvement in the leading indicators. The graph below shows the improvement in the Purchasing Managers Index for China, the US and Europe.

Purchasing Managers Index for China, the US and Europe

To be sure, the leading indicators are still poor, but much of the tail risk for the global economy has diminished, which is having an important flow through benefit in lowering risk premia.

Equity market sentiment was also helped by the US Q1 reporting season which handsomely exceeded expectations, including some very strong results in the beleaguered banking sector. The lift in sentiment from the positive earnings surprise has been assisted by improving trends in pre-announcements and earnings revision.

In addition, credit markets continue to improve, including outsized rallies in investment grade, high yield markets, and a resumption of high levels of primary credit issuance. These are very encouraging developments as the vicious circle between deteriorating credit markets and the economy has turned into a virtuous circle, at least for the time being.

Looking forward, further improvement in the economic outlook appears likely as the inventory cycle still has some way to run and the global easing of fiscal policy will provide additional support. In addition, some key areas of demand have reached extraordinary lows (such as global auto sales and housing activity) yet appear to have stabilised. Some bounce might reasonably be expected in the year ahead.

We continue to view the structural headwinds facing this rally as formidable. In particular, the household sector balance sheet has been hit very hard by the massive falls in real estate and equity prices. The deleveraging process is ongoing and will lead to disappointing global economic growth in coming years no matter how successful governments and central banks are in engineering an economic recovery later this year. In particular, our confidence in a sustainable recovery based on private sector demand remains low at this point.

Moreover, whatever the results of the forthcoming stress test, the pressure on the global financial system remains intense and credit creation will necessarily be heavily curtailed in even the most optimistic scenarios. In particular, the efficacy of the process for getting toxic assets off bank balance sheets remains in doubt (particularly in light of the less than stunning debut of the TALF).

Some of the key themes underpinning our current views are:

Emerging markets (particularly in Asia) out-performing developed markets as these economies are in much better shape fundamentally having deleveraged in the wake of their crisis in the late 1990s.
Deflation is the key risk for the next 2 (or maybe 3) years in developed economies. Inflation fears appear to be overdone in light of the enormous output gap created by the deep global recession.
Notwithstanding, the signs of a tentative recovery in global economic activity, central banks are extremely unlikely to raise interest rates for the foreseeable future and in some cases (Australia, NZ and many emerging economies) further cuts are likely.
Potential disappointment in some commodity markets that have been rallying recently (largely on the improvement in the outlook for the Chinese economy) as global IP growth will likely be sub par for many years.
Long term government bond markets should be strong given the economic backdrop and the quantitative easing policy in some jurisdictions, but at this stage they appear to be overwhelmed by supply.

Outlook

We remain sceptical about the longevity of any rally in risk assets, but we have to acknowledge the improvement in the global economic leading indicators (with further improvements likely), better than expected company profits and the recovery in credit markets - all of which have exceeded our expectations. It may be that these factors hold sway for some months before the longer term structural headwinds reassert themselves.

Investment Review and Outlook is reproduced with the permission of BlackRock Investment Management (Australia) Ltd (BlackRock) and is written by David Hudson.

Important Information

Information provided in this newsletter is general in nature and does not constitute financial advice. While I have taken reasonable care in providing this information, it should not be construed as being specific to your investment objectives, financial situation or particular needs. It's important for you to consider these matters before making any financial decision and we recommend you seek financial advice.

Investment Review and Outlook Apr 2009

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