Investment Review and Outlook Mar 2009

Is this the end of the bear market or just a false start?

Over the past month, despair has been overtaken by growing optimism that the lows for this punishing bear market might have been made in early March. The arguments cited in favour of the durability of this change in sentiment include:

• The strength of the rebound in equity markets, supported by attractive valuations and the deepest peak to trough fall in the US equity market since the Great Depression;

• Equity markets are generally forward looking and bottom ahead of the economic recovery and there are a number of ‘green shoots' globally pointing to a slower pace of decline in the global economy and a possible recovery later this year supported by easier fiscal policy and an inventory cycle;

• The activism of governments globally in announcing yet more measures to address the global financial crisis including the G20 meeting (agreeing to, inter alia, increased funding for the IMF and a raft of new regulations for the financial system), more fiscal easing (for example, in Japan) and the US Public-Private Investment Plan (PPIP), designed to take toxic securities and loans off bank balance sheets;

• The activism of central banks, including the US Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank all embracing some form of quantitative easing;

• An easing of mark to market rules in the US taking some pressure off US banks (at the expense of more opaque balance sheets); and

• Some continued recovery in credit markets, particularly those areas that are perceived to be direct beneficiaries of government programs. This is helping to expand credit provision and lower borrowing costs for households and businesses.

We are, however, not convinced about the durability of this rally. It does seem clear that the pace of the decline in the global economy - having been widely characterised as ‘falling off a cliff' following the Lehman's failure - has passed its peak. Six months later, the parachute is out which is unquestionably good news. But the global economy is still contracting and it is still too early to say whether enough has been done to deliver a sustainable economic recovery. This is the pivotal issue for markets.

The bear case remains powerful as the consumer in developed economies will have to contend with confidence sapping job losses and (in some cases) ongoing falls in house prices at the same time as the gains in discretionary spending power due to lower commodity prices have passed. In addition, we are not at all convinced that the US housing market and the global financial system are on a path towards stabilisation, which appears to be a pre-condition for a sustainable economic recovery.

The current generation of global investors are used to government actions being followed by sustainable economic recoveries. But governments and central banks don't always get it right and sometimes they are simply overwhelmed by the scale of the problems. In particular:

• The G20 meeting did not agree to anything that would increase confidence in an imminent global economic recovery - the increased funding for the IMF is a ‘good thing' in that it will help some developing economies over the long run. But these economies remain in a perilous position and they face some very unpalatable choices. Many of the other measures were aimed at avoiding a repeat of the current debacle. These policies will be important to get right, but they will not help the global economy to get out of the current malaise.

• The PPIP program is also an important step in the right direction and it may well help to get some toxic securities off bank balance sheets as these have been marked down aggressively in many cases. However, it will probably not help to get toxic loans off bank balance sheets as these have not been marked to market. The over-riding question remains how to re-capitalise the banks once these toxic assets have been removed. TARP is all but fully accounted for and the poisonous political atmosphere in the US right now suggests it will be very difficult to secure more public funds to re-capitalise the banks. And the losses incurred by the private sector from previous investments into US financials make it difficult to envisage further private sector investment in banks.

• The quantitative easing measures by some global central banks effectively represents a further easing of monetary policy, but we have been disappointed with the lack of follow through buying of government bonds. It appears that the enormous scale of issuance by governments (added to the government guaranteed issuance by banks) may keep real interest rates uncomfortably high.

Outlook

At this stage, our central case would be that any sustained recovery in private sector demand is more likely in 2010. As a result, we are more inclined to look for opportunities to reinstitute risk adverse positions.

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.