Investment Review and Outlook Feb 2009

by Andrew Newman
in Economy
28 Mar 2009 | 0 Comments

Setting the scene for 2009

The current economic and financial backdrop for markets is the most challenging since the Great Depression in the 1930s:

The global economy is in a severe synchronised downturn.
The inflation scare of 2008 turned out to be a giant head fake and now deflation is the big risk.
The financial system has been totally overwhelmed by losses on an enormous scale.

It is not true that this is unprecedented. It has all happened before, but not in our life time. Short of conducting a séance with policy makers and investors of the 1930s we are light on for practitioners with hands-on experience of this kind of environment! We can read the books and study the history, but economics is not a scientific experiment so uncertainty and flexibility must be over-riding considerations in the outlook.

There are some reasons to get excited about the outlook for equities. For example, the 10 year return from US equities of -0.3% per annum is the lowest since the 10 year periods ending in 1937, 1938 and 1939. Such periods of disappointing returns are normally followed by strong returns as the risk of a major fall in the valuation of the market dissipates. And equity valuations are more attractive relative to bonds than any time since the early 1980s, which immediately preceded a great bull market.

Despite these encouraging signposts, we are still very cautious tactically. In 2009 and 2010, the global economy will be characterised by private sector retrenchment on a massive scale. It is unavoidable. Credit will be difficult to get from an impaired financial system. Households will be looking to repair their ‘balance sheets' by increasing savings. And companies will be curtailing their activities as profits fall and capital is hard to access. The net result is that private sector demand (about 80% of the economy in the developed world) will be very restrained under the most optimistic scenarios in the next few years.

On the other side is a huge expansion in the public sector as policy makers are reacting very aggressively to counter the collapse in private demand. Policy makers around the world are operating on a number of fronts:

Fiscal policy is being eased dramatically around the world as governments crank up spending, tax cuts and hand-outs to try and fill the hole in demand;
Interest rates have been slashed to multi-decade (or in the case of the UK, multi-century) lows; and
Repair of the financial system through capital injections, liquidity measures and insuring losses from bad assets.

The problem is it is impossible to calibrate the response precisely. If it works, we might get a nasty dose of global inflation in 3 to 5 years time. If it doesn't, the recession this year will be much more severe and any recovery will be postponed past the second half of this year. In this environment deflation could become entrenched. The market is expecting a recovery in the second half of this year, which appears to be the best case scenario, so there is plenty of room for disappointment.

In addition, the valuation case for equities over bonds is not as clear cut as many would have you believe. It is true that equities appear as cheap as anytime in the past 25 years. Price to earnings ratios are less than 10 in Europe and less than 15 in the US against a backdrop of extremely low interest rates (policy rates are zero to 2% in the US, Japan, UK and Europe and bond yields are at multi-decade lows). Consequently, the earnings yield of the US equity market has now reached its cheapest level compared to real bond yields in 25 years.

A longer history, however, reveals a much more ambiguous outcome. In fact, if we go back 85 years equities are around fair value relative to bonds. This suggests to us that the relative performance of equities and bonds will depend on the economy. If the global economy begins a sustainable recovery in the second half of 2009 it could be expected that equities will handsomely out-perform bonds this year. Conversely, if the economic recovery is late, or disappointing, bonds might continue to out-perform equities.

These uncertainties suggest that medium term investment strategies could be very costly (again) in 2009.

Australian economic outlook on a knife edge

Against this backdrop, the outlook for the Australian economy is delicately poised. There is no doubt the policy response from the Reserve Bank and the government has been emphatic. Moreover, the monetary policy transmission mechanism in Australia still works as is evidenced by the big fall in the variable mortgage rate (as the banks have been able to pass on much of the fall in cash rates). But the global headwinds are at gale force. This is the deepest global recession since WWII and Australia's trading partners are being hit hard. For example, the Reserve Bank estimates that growth in Australia's trading partners in the December quarter was -1.75% (or -7% at an annual rate). The commodity price boom is over and now the only question is - how big will the bust be in the terms of trade? Unfortunately, history suggests big booms are followed by equally big busts!

The Australian economy shares many of the same characteristics as the other Anglo economies which are now all in recession, namely - a very large current account deficit, very low household savings rate, a huge boom in real estate and high household debt levels. So far, we have been somewhat insulated from the global economic fall-out by the strong performance of the banks and by the sky-high contract prices negotiated for coal and iron ore last year. A big fall in these prices is all but assured in the June quarter. At that time, we may look like most of the other Anglo economies - just 6 to 9 months behind.

There is, however, one glimmer of light. The China boom has, of course, been instrumental in Australia's current prosperity. The Chinese economy slowed precipitately at the end of last year and the Chinese authorities have responded with a dramatic easing of monetary and fiscal policy. There are some tentative signs that these policy measures might be working (including a pick up in bank lending, money supply and some marginal improvement in purchasing manager indices). If this translates into increased spending, the recession in Australia may be quite shallow. If not, the terms of trade are likely to crash down in the next couple of years implying a severe hit to Australia's national income. The success of the Chinese authorities in restarting growth will be critical to the performance of the Australian economy.

Conclusion

Our overarching themes for asset allocation in 2009 are:

The risk to the consensus expectation of a recovery in global growth in the second half of this year is clearly to the downside. Australia is 6 to 9 months behind in this economic cycle.
Excessive debt of households and businesses will continue to be a major theme in markets as scarce capital will make high gearing either unavailable or very expensive.
Current account deficits will matter for currency markets in a capital constrained world. Attracting capital inflows to fund a large current account deficit will likely require a cheaper currency.
The equity bond call remains very difficult and will ultimately depend on when a sustainable recovery starts. We expect the market to be disappointed in their current expectation of a recovery in the second half of 2009. Given equities trough months before the recovery begins we still expect equities to reach their lows some time this year - most likely in the second half.
Listed growth assets may make their lows this year, but unlisted growth assets (which have out-performed so far) are likely to have a multi-year correction.
Government bonds are expensive but are likely to stay that way given the near term prospects of deflation in the major economies. Monetary policy will stay extremely accommodative for a long time with zero or near zero interest rates in many of the major economies. Moreover, quantitative easing (where the central bank buys government bonds and/or other assets) will be required in order to ease financial conditions when real interest rates are too high because of deflation.

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

1. As pointed out by Tim Bond of Barclays Capital.
2. The terms of trade are the ratio of export prices to import prices. In Australia's case, the big driver of the terms of trade is commodity prices.

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 Feb 2009

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