Investment Review and Outlook Jul 2009

A tug of war remains

Risk assets powered ahead in July after a flirtation with key support levels in equity markets early in the month. It remains a tug of war between the opposing forces of private sector deleveraging and the massive policy response from governments around the world. The policy response was overwhelmed by deleveraging until March this year, but since then we have had a massive reversal as policy finally received some traction in markets and the economy.

Just as importantly, the key drivers of the recent improvement in risk appetite, as outlined below either remain in place or are getting better:

• Macroeconomic data are consistently surprising on the upside which has in turn driven an upward revision cycle in growth estimates globally.

• Importantly, these data surprises include some tentative signs of stabilisation in the US housing market (prices and activity) and a massive ramp up in auto production.

• Continued improvement in credit markets as spreads continue to narrow significantly as shown in the graph below.

• Extremely stimulative macroeconomic policy settings around the world, including cash rates of zero to one percent in most of the developed world, remain in place with no sign of an early change to tighter policies.

Added to that, the profit reporting season in the US has been notable for handsomely beating expectations, not withstanding the biggest revenue decline on record (since 1938). Expectations have been exceeded via cost cutting implying very strong productivity growth in the first half of 2009 and quite resilient profit margins considering the severity of the recession. Moreover, guidance has improved as companies' report that the economy is bottoming out.

In our opinion, this rally in risk assets more than likely has further to go, while the economic data and credit markets continue mutually to reinforce each other. In particular, our analysis suggests that the market consensus is yet to fully embrace this rally in risk assets. After such a horrific bear market, there are many sceptics about this rally, providing ample scope for equities to ‘climb the wall of worry'.

Of course, the harder question to answer is whether this is the start of a new bull market, or a bear market rally to fade? The first point to make is that we are in uncharted waters. We know that balance sheet recessions are deeper (which has already occurred) and are followed by more sluggish recoveries than normal recessions. However, the degree of stimulative policies globally is also unprecedented. In that sense, the global economy is effectively being subjected to an experiment. So far, it seems to be going well, but we will not know for sure if it has been successful until the deleveraging is over, and governments and central banks have successfully exited the current extreme policy settings phase.

Outlook

As a result of these massive opposing forces, we plan to maintain a flexible mindset. Up until now, we have rated the chances of a V-shaped recovery as very low, but there is undoubtedly a V-shaped recovery forming in the global manufacturing sector. Indeed, reputable forecasters are looking for the strongest annualised pace of manufacturing output growth in the second half of 2009 since the mid 1980s. By contrast, the signs of recovery in the services sector are less convincing. And there remain major questions about the outlook for the global economy, once the fiscal stimulus fades and the inventory cycle in the manufacturing sector runs its course.

Consequently, we will remain alert for signs of prospective renewed deterioration in the global economy or another bout of risk aversion. 

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.