Investment Review and Outlook Aug 2009

by Andrew Newman
in Economy
28 Sep 2009 | 0 Comments

Policy response from governments around the world is gaining traction

Up until March this year, asset markets and global economic activity had been tracking quite closely with the Great Depression. Confidence in the economy and markets was shattered and even the optimists conceded that the downturn would be deeper and longer than usual. This crisis however has been different in the sense that it has also been met by a forceful coordinated policy response by central banks and governments. And the policy response appears to be gaining traction.

As a result (and against our expectations of just a couple of months ago) the probability of a V-shaped global economic recovery in the developed economies has increased markedly. It may ultimately peter out into the tepid growth that is widely expected over the next few years. But even if it did, a short lived V-shaped recovery into the middle of next year would continue to drive a recovery in risk assets over the remainder of 2009, in our judgement.

The reason why it might look like a ‘V' for a while relates to the nature of the downturn. In the latter part of last year and early this year, the private sector retrenched massively to guard against the possibility of another Great Depression. Businesses cut capital expenditure, employment and inventories in an attempt to get out in front of a potentially calamitous economic downturn. Households cut discretionary spending and raised their saving rate out of current income as widespread retrenchments dramatically increased job insecurity, for those still in work. It was all mutually reinforcing and round after round of macro policy stimulus measures from governments and central banks around the world seemed powerless to stop the global economy unravelling.

What has changed? First, the developing economies began to rebound, led by a remarkable resurgence in Chinese economic growth. Second, the inventory cycle kicked in - production in the manufacturing sector had been cut back well below sales globally, and has recently begun to ramp back up, to slow the rate of inventory reduction. The chart below of the US Manufacturing Purchasing Managers Index is a good leading indicator showing this rebound in manufacturing.

US Manufacturing Purchasing Managers Index

Third, credit markets began to thaw which has significantly increased the efficacy of highly stimulative monetary policies. Fourth, the fiscal stimulus enacted during the dark days of late 2008 and early 2009 is having its maximum impact now, and will not begin to become a significant drag on growth until next year. And finally, consumption spending has stabilised globally. Although US consumption spending remains very weak, there are some tentative signs of improvement in the US housing sector. The chart below shows the strong recovery in Australian consumer confidence.

Westpac Institute Consumer Confidence Index

As a result, global economic activity has clearly improved and confidence is rebounding strongly. The extraordinary pre-cautionary steps put in place by the private sector (just in case this was a re-run of the Great Depression) are now being unwound. This process could look very much like a traditional V-shaped recovery, before the private sector de-leveraging re-asserts itself.

In this respect, it should be noted that the monetary and fiscal authorities around the world are very pleased to have taken the global economy out of its nose dive. Apart from a few isolated cases (including China and Australia) there is no appetite to start the process of withdrawing the extraordinary stimulus measures put in place in the six months following the demise of Lehman Brothers. Core inflation has fallen significantly in the past 12 months, with further falls in prospect given the size of the output gap globally. Furthermore, there are widespread fears of a double dip back into recession which is widely perceived as the bigger risk for policy makers in the next 12 months. Consequently, we expect macro policy to remain extremely supportive of economic growth for the foreseeable future.

Outlook

This is the sweet-spot of the economic cycle for risk assets. We believe equities and other risk assets remain well placed to continue to ‘climb the wall of worry' over the remainder of 2009.

The major risk in the near term appears to be a policy miscalculation by the Chinese authorities who are starting to pull back from the stunning measures undertaken to revive growth. They have no interest in overdoing the restraint, as inflation remains quiescent and political stability is best served by strong growth with low inflation. But the economy has swung from stagnation late last year to extremely strong growth six months later accompanied by explosive growth in money supply, bank lending and speculative activity in equities, commodities and property. Trying to rein in the excesses will be difficult, but we would back the authorities to pull it off at this stage. We would note, however, that a longer lasting set back in the Chinese economy, at some point over the next few years appears inevitable.

Against this backdrop, we continue to favour ‘risk' assets for now including equities and carry currencies (when an investor sells a currency with a lower interest rate to purchase a different currency yielding a higher interest rate). Many of the carry currencies have a commodity flavour which will be buffeted by sentiment surrounding China. Overall we expect commodities to consolidate the recent rebound, in light of the likely boom in global industrial production, even if Chinese demand pulls back somewhat. In bond markets, we favour tactical short positions, and yield curve flattening as activity is likely to post more upside surprises. The supply of bonds is huge and core markets have rallied to the bottom of recent yield ranges.

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 Aug 2009

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