Investment Review and Outlook Dec 2008

by Andrew Newman
in Economy
28 Jan 2009 | 0 Comments

2008 - A Bevy of ‘Black Swans'!

Displaying exquisite timing, the financial markets author Nassim Nicholas Taleb, published a book called ‘The Black Swan' in 2007. Wikipedia says "the term black swan comes from the commonplace Western cultural assumption that ‘All swans are white'. In that context, a black swan was a metaphor for something that could not exist. The 17th Century discovery of black swans in Australia metamorphosed the term to connote that the perceived impossibility actually came to pass." Taleb's version of a black swan as it applies to financial markets is a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. Well, there have been a few of those this year!

At the end of the most tumultuous year in financial markets and the global economy in decades it is time for a stock-take. As you all know too well, the wealth destruction this year has been incredible and there have been few places to hide.

The origins of this crisis lay in credit markets. The big boom in credit since the early 1980s is reversing and the consequences are devastating. Investment grade credit spreads looked attractive at the start of the year and yet have marched ever higher all year as wave after wave of de-leveraging has unleashed massive selling pressure of high quality investment grade credit. The supply of these securities is enormous and yet the natural buyers of credit had already bought the market a long time ago. Moreover, the intermediation of these securities has frozen up as the business model of the highly levered investment banks has effectively broken down. The result is credit markets are priced for an economic scenario worse than anything we have seen since the Depression. This is at the heart of the crisis and while the authorities have been extremely active with a range of measures designed to thaw credit markets it still is not fixed (a point to which we shall return in the outlook section later).

Equity markets are down around 40% at the time of writing and if we hold current levels this will be the second worst year (after 1931) in the US equity market in the past 185 years! The peak to trough fall in the market has been 52% which already exceeds the severe bear markets of the post war period.

These metrics are suggestive of an extreme and oversold market. We would agree with that assessment, but we would also caution that it can easily get worse. For example, what followed the worst year ever in US equities in 1931 was a further 50% drop in the first half of 1932. And while this is already the worst bear market in the post war period in terms of price falls, it is not as long as the bear markets in the mid 70s and early 80s. These bear markets were associated with severe global recessions, like the one we are in now, and both lasted 21 months. On that metric, the market will not reach its low point until the middle of 2009!

Commodity markets have been a wild roller coaster ride with major gains in the first half of the year - at the time that the decoupling thesis was alive and well(1)- followed by a stunning collapse in the second half of the year. The only exception was gold which managed to be unchanged over the year (although that did not help gold mining companies, many of which were hit by the credit crunch). As the Reserve Bank Governor remarked this week the Chinese economy has slowed significantly since the middle of this year. The coming bulk commodity price negotiations are likely to be extremely tough for the mining companies and a massive reversal in Australia's terms of trade is in the offing next year.

Similarly, currency markets have been extremely volatile. The big moves have been in commodity currencies (including the $A which has had a staggering fall from its high); a massive appreciation of the Japanese Yen as the ‘carry trade' unwinds; and big falls in emerging market currencies. The fall in the $A has been good news for our exporters and import competing companies. However, the magnitude and unprecedented speed of the fall caused many hedging strategies to come unstuck.

2009 Outlook - Some Initial Thoughts

The global economy and financial markets will enter 2009 in extremely poor shape. The leading indicator for every single economy of the 35 we track is negative. Moreover, an unweighted average of this leading indicator is 4 standard deviations negative (another black swan?). Previous severe recessions have got to just minus two standard deviations on the unweighted average. And 5 of the 8 weakest countries are China, Australia, US, Eurozone and Japan. The leading indicators of inflation are also similarly extremely weak, although the coverage is much smaller.

It appears likely that in the first half of next year the global economy will be in the deepest global recession (in real and nominal terms) than anything we have seen since the depression. This is not to say it will be anywhere near as bad as that, but the irony is the inflation scare in 2008 looks like turning into a deflation scare in 2009.

These conclusions are reinforced when we look at credit markets which remain in a deep funk. The bursting of the credit bubble got us into this mess and now the credit crisis and the global economic recession are mutually reinforcing. The inability of companies to raise money in credit markets will continue to put pressure on equity markets as companies are forced to raise money through equity issuance. Moreover, investors wanting to invest in risk assets can gain equity-like returns and be higher up the capital structure by investing in credit (albeit with less liquidity). For these reasons, a substantial recovery in credit markets seems a pre-condition for any sustainable recovery in other risk assets and such a recovery remains elusive. Consequently, we continue to be sceptical of any sustained rally in risk assets at this stage.

Indeed it seems most likely that this bear market lasts 18 to 24 months implying the low in markets will be between April and October next year. The most optimistic scenario we would put forward is that we successfully retest the November lows in equity markets in April next year. New lows in equity markets in 2009 are, in our view, more likely.

While we remain tactically bearish on markets we will be staying flexible in our views. It has not been a set and forget investment environment in 2008 and it won't be in 2009. In an extreme macro environment, we expect there should be many good risk/reward investment opportunities across markets, aside from the most important (but also very difficult) call as to when to buy risk assets (including equities). That said, we expect a very good opportunity to buy risk assets will emerge over the course of 2009.

Stay tuned for the review of the top 10 predictions of 2008 as well as the top 10 predictions for 2009 in February and in the meantime we wish our readers a happy holiday season.

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

1. The decoupling thesis was that parts of the global economy could continue to grow strongly (in particular, China and many other emerging economies) while the US and some other developed economies slowed dramatically.

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 Dec 2008

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