Investment Review and Outlook Jun 2009

by Andrew Newman
in Economy
28 Jul 2009 | 0 Comments

Policymakers save the day ... for now

Over the past two and a half months the global economy has consistently performed better than expected. Admittedly expectations were totally bombed out, but that is the first time in almost two years that economic growth has not disappointed expectations, most spectacularly in the final quarter of last year when the global economy collapsed. Over this period, the policy response was consistently overwhelmed by the unfolding global financial crisis.

So far in 2009, the trends have been less clear cut, yet volatility has remained high. The policy responses from central banks and governments have finally received some traction after a vast array of measures were adopted:

policy interest rates have been cut dramatically everywhere to the point where in much of the developed world they are zero to 1%;
in a number of countries (including the US and UK) these measures have been supplemented by so called quantitative easing measures, designed to further lower interest rates for borrowers;
similarly, fiscal policy has been eased substantially, with budget deficits in the double digits as a percent of GDP in a number of countries; and
finally, a wide variety of innovative programs have been introduced in an attempt to deal with the liquidity and solvency issues in the financial sector.

The dominant influence has been the waxing and waning of sentiment as to whether:

on one hand, the global financial crisis is the dominant influence on the outlook, and policy is impotent; or
on the other hand, whether policy is going to work ushering in a sustainable economic recovery later this year.

The first quarter of this year was characterised by despair as a depression type scenario was priced into many markets. This flipped dramatically in the second quarter as tail risks began to be priced out of markets and some optimism surfaced that a global economic recovery might start in the second half of 2009.

The case for optimism rests on a few considerations:

credit markets have rallied strongly and now there is a much more constructive supply-demand balance in these markets;

Global Broad Market Corporate Index

China is recovering strongly, supported by a massive fiscal package and a dramatic increase in credit provision;
the fiscal policy impact in many other economies is at its maximum right;

US Fiscal Deficit as a percentage of GDP

the manufacturing sector has bounced spectacularly in Asia which will be followed by a smaller but still emphatic manufacturing recovery in the developed world in the second half of the year, driven by an inventory cycle.

These drivers should be enough to end the global recession in the second half of the year. Beyond that, uncertainties abound. To some extent, we are in uncharted waters. We know that recessions associated with financial crises are longer and deeper and recoveries are notably weaker. The fact that this financial crisis is global serves to under-score this conclusion. The unprecedented policy response on this occasion is however the major consideration pointing to a stronger recovery.

The deleveraging process in the private sector, including the banks themselves, is the most important factor driving the outlook. This is necessarily a long drawn out affair reflecting the nature of the price discovery process in illiquid markets. The re-leveraging of government balance sheets is an important offset, but there are limits, which seem to have already been reached given the back-up in bond yields witnessed so far this year. As a result, we expect fiscal policy to become a drag on growth next year (even if there are further packages they won't be on the same scale). The inventory cycle is also a one-off.

Outlook

Therefore, for the expected recovery in the second half to become entrenched, we will need to see some improvement in private sector demand. This is plausible as the level of private sector demand in many countries is extremely low (eg. US auto sales and housing activity). But the balance sheet impairment caused by the fall in house prices and stock-markets suggests private sector demand will ultimately disappoint. The most optimistic scenario in our judgement is a tepid recovery as the balance sheet adjustments in the private sector act as a major burden on global growth. A V-shaped recovery appears to be the least likely scenario and it is far more likely the global economy will double dip back into recession in late 2010 and 2011. In summary, for most of the past 12 months the global economy has performed dramatically worse than expected and financial markets priced in ever more dire scenarios for the outlook. Over the past two and a half months the tail risk has been priced out of markets again as the global economy finally pulled out of its nose dive.

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 information provided is general in nature and does not constitute financial advice. While we 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 Jun 2009

Leave A Comment