Investment Review and Outlook May 2009

Optimistic tone alleviates market volatility

The more optimistic tone in risk markets continued throughout May with a further significant extension of recent market moves including rallies in credit, equities, commodities and commodity currencies.  Meanwhile, the sell-off in government bond markets and the US dollar also continues to extend further.

There are a number of positive developments for the global economic outlook:

• Global leading indicators continue to improve and growth forecasts are being revised up;

• In particular, the Chinese economy is recovering as the government's extraordinary reflationary efforts have clearly worked (at least for now);

• Partly reflecting these developments, the internal dynamics of the leading indicators suggest a recovery in the manufacturing sector is more than likely later this year (even if final demand does not recover) as the inventory cycle kicks back; and

• The recent dramatic steepening of the yield curve is a very constructive sign for the global economy.

Most importantly, the improvement in the outlook for the global economy continues to be reflected in much better credit markets which are, in turn, feeding back into optimism on the global economy. The vicious spiral of 2008 and early 2009 has been replaced by a virtuous circle. As an indication of how far we have come in a short time, the Governor of the Reserve Bank of Australia recently mused that the massive policy response to the global downturn might cause an upside surprise in global growth. To be sure, this is not the RBA's central case but it does highlight an emerging risk which was unthinkable three months ago.

Credit markets continue to perform strongly as the imbalance between supply and demand has flipped from massive excess supply to massive excess demand. Investors are rushing to take advantage of credit spreads that are still extremely wide by historical standards. The recovery in credit is being led by the financial sector where nationalisation fears caused devastation in debt (and equity) securities earlier this year. The solvency concerns which dominated at that time have been allayed by the stress test (at least for the time being). Just as importantly, operating profits have been very strong and the recent further steepening of the yield curve only underscores how positive the environment is for the trading profits of banks this year. Moreover, since the stress test and the Q1 profit reports, banks have been able to raise significant amounts of private capital in a manner that was unimaginable just three months ago.

Reflecting these developments, many markets have returned to their pre-Lehman's levels - an extraordinary recovery when set against the devastation of the global economy over the past nine months and the structural headwinds to any recovery in global economic activity. The constructive supply demand balance underpinning the recovery in credit markets is still in place which implies that further credit spread contraction may continue to be the path of least resistance.

Equity markets continue to be reasonably well placed to climb the 'wall of worry' even though the rally, off the recent low, is already stunning and a period of consolidation would not be surprising. Equity market volatility is subsiding and on our assessment equity investors are not yet overly bullish in a way that would threaten the rally. Indeed, the process of rusted-on bears being forced back into the market is not yet mature partly because there have been no pull-backs to allow investors to increase exposure to risk assets.

The return of longer dated US Treasury yields to their pre- Lehman levels reflects the countervailing forces of a severe global recession and short term risk of outright deflation set against massive supply (including government and government guaranteed bank debt) and longer term inflation risks. At this stage, we do not view the back up in yields as enough to threaten the recovery in risk assets. Much of the increase in yields has been due to a re-pricing of inflation risks which we view as constructive for equity markets. Longer term breakeven inflation rates have backed up substantially, but are still less than 2% (for the 10 year bond) which would be a remarkably good outcome. The extent of any increase in real yields depends on the time frame. Real yields have increased dramatically if the measure is nominal bonds versus the one year forward inflation outlook. The increase however is quite modest when set against longer term inflation expectations as is highlighted by longer term Treasury Inflation Protection Securities (TIPS) which have performed well during this bond sell-off.

Similarly, the rise in commodity prices is more likely to reflect a more constructive outlook for global economic growth than constitute a threat to global growth at this stage. Moreover, we have doubts about the sustainability of the rally owing to the significant increases in inventories of oil and some base metals. The rally in commodity prices has been spurred on by a much weaker USD. In a risk seeking environment, the US dollar has become the favoured funding currency for carry trades which has seen commodity currencies stage big recoveries after the stunning meltdowns last year.

We still question the sustainability of these trends given the structural headwinds faced by developed economies and the overwhelming evidence pointing to subdued recoveries following financial crises. So far we have had a massive rally on 'less bad' news. At some point, we will need 'good news' for the rally to persist. In addition, some recent developments in credit markets suggesting a more adverse environment for credit investors going forward (such as the terms of the Chrysler bankruptcy) have been ignored by the markets so far but could come into focus later this year or next year.

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.