Looking ahead-3

In our view, the so-called ‘relief rally’, which began in March of this year and has continued apace ever since, has run too far and too fast, ignoring some very fundamental headwinds. We believe these will ultimately temper expectations and call for a revision of current valuations. We monitor and assess numerous data series and factors as we shape our views and this process has consistently distilled the following five issues:

A weak banking sector - the banking sector in the developed world remains weakened by the financial crisis and asset quality is deteriorating as the household and corporate sectors struggle to service debt. The IMF recently published their Global Financial Stability Report and while they commented the state of the real economy was improving, banks ‘remain under strain’ and they restated their view the global banking sector losses would still reach US$2.8 trillion. For the first half of 2009, circa US$1.3 trillion of write-downs have been reported suggesting we are only half way through the necessary unwind. In other words, if the IMF is correct, significant write-offs still remain to be taken within the banking system. Additionally, banks are already considered under capitalised in the light of pending regulatory reform and this will limit their ability, and appetite, to lend. The flow of credit through economies will continue to be restricted and this does not augur well for a robust, sustainable economic recovery.
Consumer deleveraging - the over indebtedness of the Western consumer is well documented. We know savings rates are rising; however, household balance sheet repair has only just started and will take a number of years to correct. Data from the Federal Reserve showed that consumer credit declined by $21.6bn in July, or 0.9%, the biggest drop in percentage terms since 1975 and more than double analysts' expectations. Unless consumer spending can pick up the baton from the current rebound in economic activity, prospects for both Western economies and their equity markets must be muted. With unemployment set to continue to rise through 2010, we think consumer demand will be weaker than markets have priced in.
Corporate capital expenditure cuts – a recent survey in the US revealed that 79% of CEOs questioned expect capital expenditure to be flat or down over the next six months. Management teams are not confident about the strength of the recovery (see consumer demand above) and top-line sales growth is difficult to capture. This is endorsed by the fact that the majority of the released second quarter ‘better-than-expected corporate earnings figures’ had a high reliance on one-off cost savings, rather than growth in repeatable revenue earnings.
Public sector weakness - the governments of the Western world have amassed enormous debts as a price for the substantial stimulus packages introduced. GDP growth this year has been almost exclusively derived from public sector spending. This must, however, be cut and, given the weakness of the private sector, this will be a very strong headwind against economic recovery. Logic would dictate that public spending must be curtailed and taxes raised, draining consumer-spending power still further.
Policy risks – the IMF believes it is too early to withdraw official support policies, but a strategy for disengagement is needed. As speculation grows to when policy changes will be announced, we are almost certainly likely to see higher bond and currency volatility, rising bond yields, and inflation concerns grow. The likelihood of perfectly timing the reversal of this unprecedented support is remote and confidence in the economic recovery will be very vulnerable to ill-judged policy mistakes.

Conclusion

In the midst of this ongoing surge in asset prices, we feel it is important to take a step back from the daily noise that is commonplace in the investment management industry. While we would not deny that the worst is over and Armageddon has been avoided, we would argue that the above five issues indicate we are a long way off a full recovery.