Richard Smith – The Finance Zone – Market Commentary – September 2009
Equity markets have rallied sharply since early July, during what is usually a quiet time of year (whatever happened to “sell in May and go away”?), encouraged by a better than expected earnings on both sides of the Atlantic and by signs that most developed economies were emerging from recession. The rallies continued to be confined mostly to the “up and down” sectors which had both plunged and bounced fastest in the past year, financials, mining stocks and industrials. More recently, however some of the more defensive sectors have also joined the party.
Central banks have been at pains to say that monetary policy will not be tightened prematurely, which, given their role as guardians against inflation, underlines the strong desire to avoid repeating last winter’s brush with the risk of a full blown economic depression. They have also emphasised the many risks to the recovery. These include too much personal debt, too little bank capital and too much public borrowing. Central bankers clearly believe that domestic inflation pressures will remain contained by the spare capacity created by the recession. It is less certain whether the same applies for imported inflation, since commodity prices may be more sensitive to the rapid growth rates in emerging economies and therefore accelerate before growth is buoyant in developed economies. There could come a time when inflation from this source forces tighter policy in developed economies while they still have spare capacity, one of the downsides of globalization.
Although there are risks to the steepness and persistency of the recovery, central bankers appear set to continue to fund the overall strategy until it is clear that the recovery in confidence is sustainable. Given that there is still a significant lack of certainty over the outlook, it is fair to ask if equity markets are too easy-going in their “everything back to normal” approach. At the very least, greater care will be needed, now that the bargain basement prices have all been mopped up.
EQUITY MARKETS
United Kingdom
The UK has been slower to recover from the steeper than expected fall in output last year and early this. This has prompted the Bank of England to extend its quantitative easing policy, in turn meaning that they take a more cautious view of the recovery than the equity markets. Partly this is due to the equity market expecting recovery in 2010, and pricing that in in advance. The markets clearly expect that the reflationary policies put in place by the Bank of England will work. A revival in hopes for global growth have been reflected by forecasts for the UK, albeit slightly later for UK plc, which expect a turnaround from this year’s fall to a modest, but improving, growth rate in 2010.
The spectre at the feast remains the enormous gap in public finances which even politicians have had to acknowledge as they furiously attempt to defer difficult decisions until after the election. The markets must have their confidence maintained in the government’s commitment to sustainable fiscal policies or they will stop making money available to fund the recovery. That is forcing all parties to admit that significant cuts in public spending, and tax rises, will be needed to close the fiscal gap in a reasonable timeframe. The ratings agencies have warned that the UK will put its AAA status at risk if it does not announce significant public spending cuts in the pre-Budget report. Economic recovery and the natural ending of fiscal easing measures will not alone be sufficient to stabilise and reduce public debt burdens over the medium-term.
Given the inevitability of such fiscal policy tightening at a time when consumers are also trying to reduce personal debt and rebuild savings, the UK seems likely to be less buoyant than the global economy generally. The current competiveness of Sterling should help the usual sectors able to take advantage of this (exporters, tourism etc.).
USA
The US economy is responding to the mind-bogglingly enormous fiscal and monetary stimulus put in place over the past year. This has been helped by the fact that parts of the economy, in particular housing and the motor industry, have effectively been in recession since 2006 and may have reached the absolute low point of the cycle. Like in the UK, the absence of any real controlling process for managing ongoing budgets is likely to cause problems to investors as the economy recovers. The US political system remains open to lobbying and shows little inherent commitment to fiscal restraint, in fairness this is fully representative of US consumers, who seem to believe that the new president is installing a communist state ! The emphasis, and the easier “sell” from the Democrat-dominated Congress, remains focused on increasing spending.
The financial system appears to be rapidly weaning itself off the special support measures put in place last year, with the main remaining vulnerability being to real estate lending. This suggests that the special measures and low interest rates will remain in place for some time yet. The signs of the housing market turning up are important and, as in the UK, have the potential to be confidence inducing and self-fulfilling, as those who have waited to buy now see the market near its bottom and banks can afford to be more patient with borrowers in difficulty. Although the remaining consumer debt overhang remains a similar barrier to the UK’s problem, recovering house prices would enable savings to be rebuilt and allow a faster rate of economic growth while this was maintained.
Europe
Some European economies including, most importantly, France and Germany emerged from recession in the early summer, while others, in particular Spain and Ireland have remained weak. It is notable that both Spain and Ireland were effectively economic “one-trick ponies”, with both economies built primarily on property development and the finance thereof. There remains some concern that job losses in France and Germany have been delayed by their relatively inflexible labour laws and possibly also by the imminent German election. Rising unemployment could therefore be more of a drag on growth and output in 2010 than in countries where employment responded more rapidly to the downturn and where the worst might soon be over. If recovery arrives more rapidly in the exporting economies, such as Germany, than those that are struggling to remain competitive, such as Italy, or those whose economies grew on a financial bubble, such as Spain and Ireland, there could be renewed significant strains on the Euro. The most likely outcome of such strains is probably even greater fiscal and monetary easing rather than the end of the Euro.
Japan
The Japanese economy has begun to recover from the absolute cliff-fall in output last winter, which wiped out 25 years of output growth. The popular discontent with this crash which, let us not forget, came after nearly 20 years of stagnation, led to a political sea-change, with the opposition DPJ winning by a landslide and ending 51 years of almost exclusively one-party LDP rule. Markets are still unsure what to make of this. The new government’s policies are determinedly reflationary and are focused on reviving the domestic economy rather than targeting and relying on export growth. If they can pull this plan off, whilst still addressing the enormous legacy high-debt and high-deficit public finances, the prospects would be bullish for Japanese equities. The key issue is whether their policies can actually revive growth, which in turn would make the fiscal tightening more acceptable and politically feasible or whether they are forced by a lack on international confidence to tighten first, in which case the recovery could fail to start, yet again.
Far East Ex Japan / Emerging Markets
Emerging markets have contributed their positive growth this year, as developed economies have shrunk and, not surprisingly, they seem set to contribute the majority of recovery in 2010. In that respect, decoupling has taken place to some extent, as they have moved on being dependent on the prosperity of western markets to taking on an increasing role in actually driving the global economy. In addition to generally having a younger workforce, confidence has been boosted by general improvements in corporate governance, which has helped to attract inward investment from more conservative investors. The Asian crisis of the 1990’s led to more conservative financial policies, so emerging markets are much less dependent on foreign capital than they were before and in some cases, the dependence has actually reversed. They (in particular China) have the assets and it is the G7 countries that have the debts. The transfer of economic power from the West to the East appears increasingly inevitable.
Bonds
The last few months have seen gilt prices being pulled in opposite directions. On one hand, prices have fallen when investors have focused on the strength of the economic data suggesting that recovery will occur earlier than previously expected. On the other hand, prices have risen over the past month as investors are once again reviewing the possibility of deflation occurring over the next few years, which would clearly benefit fixed interest products. To cloud the issue further, the Monetary Policy Committee recently extended their programme of purchasing government bonds, which in turn boosted the gilt market. The money market’s perception of risk has declined substantially since earlier this year. The yield spread between 3 month LIBOR (the rate at which banks lend to each other) and Bank of England base rate has fallen back to the levels recorded before the financial crisis (about 0.15%). At the height of the financial crisis in September 2008, banks were afraid to lend to one another, fearing bank failures, and the spread widened to nearly 2%.
The performance of corporate bonds has been lively since their low point earlier in the year. In March 2009 the average difference between the returns on bond and gilts was at its widest point for eighty years at 4.4% p.a. This difference has now narrowed to 2.2%, effectively providing a total return from corporate bonds of more than 20% in 6 months. Because of this clearly corporate bonds no longer offer such exceptional value although the yields on offer are still relatively attractive when compared to those available prior to the financial crisis.
Commercial Property
UK commercial property is about to become very attractive to foreign buyers, if it isn’t already. Real values have fallen by up to 50% in some cases and the pound by nearly 30%. Norway’s sovereign wealth fund has stated its intention to invest in UK property as has the US fund manager LaSalle investment, the Australia Future Fund (who recently spent £210m on 1/3 of the Bullring shopping centre in Birmingham). These investors alone will have the potential to arrest the fall in the commercial property markets but, in addition, the major UK house-builders and property developers are looking to raise big money through the stock market in the next few months to ensure they are ready to benefit from any upturn. Although there are still major obstacles for the sector to overcome, not least the shortage of affordable finance, the sector looks sensibly priced at least.
CONCLUSION
Investors correctly understand that, over the long run, equities have delivered, and should continue to deliver, superior returns to those generated by any other asset class. They also appreciate that these returns come with much higher levels of uncertainty in any given period. During the unprecedented period we have just experienced, it is not surprising that inexperienced investors bailed out until “things settled down”. Have they “settled down” now ?
The answer is No. Things never “settle down”. The investment environment remains difficult for investors, because that is the nature of the beast. The key factor is not to have all your eggs in one basket (that inevitably lead to “bubbles”) regardless of what the experts say, and to take a long term view.
Things may well look better now than they did 6 months ago (what wouldn’t !) but in the same way that investors should not be tempted to sell what they wish they had sold a year ago, they should not be looking to buy now what they wish they had bought six months ago.
