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On track for global economic recovery

The global economic recovery is on track, supported by a very strong inventory cycle in the manufacturing sector, aggressive fiscal stimulus, and dramatically improved financial conditions. At the same time, despite the current extremely accommodative settings, there is no tightening of monetary policy on the horizon in the major developed economies as inflation remains quiescent.

There is, however, some tightening in prospect in ‘commodity' economies such as Australia and Norway. Core inflation has already fallen in the developed economies (as shown in the graph below) to around one percent. Further falls are in prospect over the next 12 to 24 months as price rises are limited by abundant spare capacity. The key risk for central banks remains deflation at this stage of the cycle, rather than inflation.

Nonetheless, sentiment surrounding the strength of the global recovery remains quite fickle. A month ago, the optimists controlled the debate with growing speculation that a ‘V' shaped recovery was possible. By the and of September, however, the period of consistently better than expected economic data appeared to have drawn to a close. This clear inflection point in the rate of improvement of global economic growth has shifted the debate to concerns about a double dip in the global economy. The concern is, that as the impact of the fiscal stimulus and inventory cycle on global economic growth dissipate, private demand will have to pick up significantly and the baton change may not be smooth.

We share these concerns; however believe it is premature to worry about them. Indeed, we still consider growth surprises are more likely to be on the upside, over the next six to nine months including:

• The inventory cycle will remain a powerful influence until early next year.

• The housing sector is showing long-awaited signs of stabilising.

• The US household savings rate has been re-built (as shown in the graph below) and is arguably adequate now that it is set against zero interest rates in the major developed economies, and the net-wealth position of the household sector.

• Financial conditions are continuing to improve as credit markets are performing very strongly and the excess of demand over supply is continuing to favour tighter credit spreads.

• The extreme synchronisation of the global economy in the past two years (on one measure, more than double anything we have seen in the past forty years) is one reason to expect more upside surprises in global economic growth in the year ahead.  

To be sure, the probability of a short lived ‘V' shaped recovery has fallen with the recent weaker data releases. But we consider it is still more likely that risk markets continue to climb the ‘wall of worry'. The extraordinary monetary and fiscal stimulus put in place at the depths of the crisis remain supportive of economic recovery. None of the policy makers in the major developed economies appear close to implementing an ‘exit strategy' - a point that was re-affirmed at the recent G-20 meeting and by the major central banks over the course of the month.

Outlook

Notwithstanding the above arguments, we remain cognisant of the fact that this is an extraordinary environment without precedent since the Great Depression. As a result, we must maintain a flexible mindset. The recent run of more indifferent economic data bears close scrutiny going forward. The short term drivers of markets will be the unfolding economic data and the US reporting season. We expect both to be supportive of risk assets however markets are priced aggressively after a phenomenal recovery since early March. As such any disappointment could be expected to cause a significant set back in risk assets. 

Investment Review and Outlook is reproduced with the permission of BlackRock Investment Management (Australia) Ltd (BlackRock) and is written by David Hudson. 

Important Information

Information provided in this newsletter 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.