Investment Review and Outlook Nov 2009

Global economic recovery continues

Global economic data has been mixed over the past couple of months, following a period of consistently positive surprises in the middle of the year. Nevertheless, it is clear that a global economic recovery began in the third quarter, with the leading indicators suggesting that the recovery remains on track for continuing growth into 2010. There is, of course, ongoing angst about the sustainability of this recovery, given the pivotal role played by governments and central banks around the world in turning the global economy around. We share these concerns, but we remain of the view that it is premature to worry about either a relapse into recession, or a sustained period of insipid growth.

The support for the global economy will continue to come from:

• extreme monetary and fiscal policy stimulus;

• a powerful inventory cycle; and

• improving business and consumer confidence.

At the same time, it is too early to expect any meaningful tightening of policy in the major core economies that are characterised by massive gaps in output, and falling core inflation. Central banks in the major developed countries continue to re-affirm that extreme settings are expected to continue for an ‘extended period'. Governments are also unlikely to tighten fiscal policy while the labour market remains weak, and government bond markets remain well supported. As we have argued before, this is the ‘sweet spot' of the economic cycle for equities and more broadly for risk assets.

Beyond this cyclical dynamic, we are also encouraged by the success that companies have had in cutting costs to meet an extremely adverse macroeconomic environment. This has been seen in the consecutive positive US reporting seasons, and the very strong productivity numbers as shown in the graph below. 

This also reinforces our confidence that the cyclical dynamic between government policy and the economy has further to run, as most of the cost cutting has been in inventories and employment. Notwithstanding the recovery in recent months, industrial production is still running well below sales in the US (and globally) and will need to be ramped up a lot further in order to slow the rate of inventory depletion, let alone re-build inventories. Moreover, the strength of the productivity numbers suggest that labour force cut-backs have been overdone and employment will stabilise in the coming months. Indeed, some of the key partial indicators on the US labour market, including jobless claims, suggest significant improvement in the labour market is imminent. This will be a major step in reassuring investors about the sustainability of this recovery.

Consequently, we expect the global economy to sustain a promising recovery during the first half of 2010 (at the very least) with the main risk in that time frame being on the upside. This should underpin risk assets, although the trajectory of their recovery will necessarily flatten out. Beyond mid 2010, the outlook becomes much more uncertain as some of the temporary supports to growth drop away and governments and central banks contemplate exit strategies.

In our opinion, the main threat to risk assets over this time, is not disappointing economic growth, but renewed speculation over the central bank's exiting from their current extreme policy position due to concerns about inflation. In this regard, it is interesting to note that market expectations of medium term inflation have deteriorated. As shown in the following graph, the implied five year average inflation rate from 2014 to 2018 (one of the measures favoured by the US Federal Reserve) increased to 2.7%.

Interestingly, this increase in inflation expectations has occurred at the same time as markets are pricing in a longer period of unchanged cash rates. 

Outlook

Ultimately, we expect the enormous gaps in output and extremely strong productivity growth to underpin an extended period of very low core inflation. The confidence of investors however in low inflation may be tested in the coming months. Over the past year, core inflation in the major developed economies has fallen significantly assisted by massive gaps in output and the huge fall in commodity prices (which feeds indirectly back into the core rate).

The year over year comparison for commodity prices is in the process of swinging from a big negative to an equally large positive. If for example, oil prices stay at current levels, they will have more than doubled by the end of this year. This will likely cause some interruption in the trend to lower core inflation. If such a scenario is accompanied by upside surprises to economic growth, it could lead to another bout of speculation about an imminent exit from emergency policy settings. Such speculation might cause a more substantial correction in risk assets than we have seen so far.  

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.