Investment Review and Outlook Dec 2009

The markets are now turning to 2010

Risk assets continue to be supported by a combination of continued ongoing economic recovery and ultra-stimulative policy settings. In particular, the US Federal Reserve reaffirmed its intent to keep the current extreme monetary policy settings for an ‘extended period'. These comments underpinned risk assets and supported a significant rally in fixed income markets globally. Meanwhile, global economic data was good enough to re-assure investors that the recovery was on track, even if it is not accelerating.

As such, the focus for markets is naturally turning to 2010 and a powerful cyclical case for robust economic growth can be seen, as outlined below:

• extreme policy settings and the rally in equities and credit has created much easier financial conditions and abundant liquidity;

• individual economies are being supported by a highly synchronised global economic recovery;

• very steep yield curves (an historically reliable pre-cursor to strong growth) as evidenced in the chart below;

• a resilient corporate sector supported by a high profit share for this stage of the economic cycle;

• a healthy balance of new orders relative to inventories; and

• household sectors have re-built their savings rate to reasonable levels, given the extremely low interest rates on offer.

Of course, the offsetting structural impediments to growth remain formidable. Indeed, this is the reason for the extreme macro-economic policy settings. These impediments were highlighted by the Chairman of the US Federal Reserve, Ben Bernanke again during November. In particular, the provision of credit by banks remains impaired and is a key constraint on households and businesses. In addition, the labour market is extremely weak which is undermining household income growth providing an additional headwind for household spending.

The difficulties of the ongoing deleveraging process were also apparent late in the month with the developments at Dubai World. While these events appear to be too small in scale to spark a relapse into widespread risk aversion, they do highlight the ongoing stress in the system caused by huge borrowings against assets that are falling in price; generate limited cash flows to service the debt; and are generally illiquid.

Finally, the global imbalances, which were a key contributor to this crisis, remain quite intractable. Demand growth needs to be re-balanced away from the developed economies towards the emerging economies; exchange rates need to be re-aligned and fiscal policy in the developed world put back on a sustainable path. There are not many signs that these adjustments are likely to occur any time soon. Refer to graph below:

Outlook

The markets are faced with two extreme and opposing forces - structural negatives versus cyclical positives. At this stage, we continue to expect the cyclical dynamic to prevail in the first half of 2010, while the inventory cycle and fiscal policy remain supportive. Moreover, in our judgement, the main risk to growth, in that time frame, is to the upside. The financial crisis reached its peak just nine months ago and global economic recovery started only five months ago. As the memory of the crisis recedes and confidence improves, it is conceivable that many companies will ramp up capital expenditure and hiring. If that were to occur, it would transform perceptions about the global economic recovery from modest and tentative, to robust and sustainable. In this context, it is intriguing that the recent trend in US jobless claims has been in line with previous vigorous recoveries in the mid 70s and early 80s.

We remain of the view that inflation risks may come back into focus given the:

• upside risks to growth;

• very low inflation numbers that are being cycled from a year ago; and

• the increase in inflation expectations in the market - reflected in higher break even inflation rates.

Such a scenario would significantly bring forward the expected timing of the first tightening of monetary policy in many countries. We remain focussed on the opportunities this may create in short dated fixed income and yield curves. We retain a bias towards risk assets (long equities and commodity and carry currencies - those with higher relative cash rates) although this position has been moderated as many of these markets have become range bound. 

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

Important Information

The above information provides an overview or summary only and it shouldn’t be considered a comprehensive statement on any matter or relied upon as such. The above information doesn’t take into account your personal objectives, financial situation or needs. It’s important for you to consider these matters before making any financial decision and I recommend you seek help from a financial adviser.