The year so far
The first half of 2009 has proved to be a rollercoaster ride for
investors. By early March, the slide in stock markets had continued
in the same vein as the final quarter of 2008, however, global
markets rebounded strongly from this March low to deliver their
best quarterly performance in 20 years. This reversal in trend was
triggered by an improvement in a number of leading economic
indicators coupled with a general acceptance the global financial
system had stabilised from a state of near collapse thanks to
coordinated government and central bank intervention. Emerging
markets have staged the most spectacular recovery, rising by 33.6%
over the quarter, making it the best quarterly performance for the
MSCI Emerging Market ($) Index since its inception in 1988. The
equity markets in China and Brazil have powered ahead, rising by
close to 60% since the turn of the year. Russian and Indian
equities have also risen sharply, the former as a result of its
high correlation to the price of oil (up 57% to the end of June)
and the latter thanks to a strong showing by the ruling Congress
coalition at the general election held through April and May.
Capital invested in these markets during the quarter has delivered
tremendous returns, however, it is important to remember legacy
investments are still significantly underwater as emerging markets
still have some way to run to reach their previous highs.
By contrast, the stock markets of the US, UK
and Europe have only returned to the levels they were at the turn
of the year, representing a significant relative underperformance.
Why should this be? The answer to this question lies in the
economic forecasts published in recent weeks by the OECD, World
Bank and IMF. In terms of global growth forecasts, economists at
the World Bank are more pessimistic than those at the OECD and IMF,
however, all three agencies are consistent in forecasting sub-par
growth in the developed world, but much stronger growth, both for
this year and next, in the developing economies of the world.
Having witnessed a period of increased synchronisation, this is now
disappearing, but for the first time, recovery is not being lead by
the US and other Western economies, it is, instead, being driven by
the East. Both consumer and capital expenditure have turned around
in China, India, Brazil, Indonesia and South Korea - such evidence
has yet to materialise in the US and Europe. Bank lending and the
flow of credit has picked up strongly in Asia and Latin America,
but still remains very weak across the G7 nations. Ironically,
second quarter earnings in the banking sector are expected to be
very strong, particularly in the US, as banks benefit from the
support engineered by central banks, together with the raft of
additional measures introduced to assist banks ease the pressures
on their balance sheets. The return of bank profitability in the US
is evidenced by the Treasury's decision to allow ten banks to repay
TARP funds having successfully passed a series of stress tests.
This much improved performance by the banks is not, however,
translating into an improving economy as lending remains curtailed,
limiting credit to both the household and corporate sectors.
Perhaps the most striking contrast between the
East and the West is the state of their public finances and the
impact this will have on the continued ability of governments to
stimulate economic recovery. The huge growth in debt and falling
tax revenues have already been a catalyst for rating agencies to
downgrade sovereign ratings and voices of concern are being raised
over the credibility of repayment plans announced by governments in
the West - particularly the US and UK - against a backdrop of
future below-trend economic growth. In the East, recent budget
surpluses and rising foreign exchange reserves have left many
countries with a pool of cash which can be used to target further
increased public expenditure and stimulate domestic consumption,
and thus drive economic growth whilst the West continues to
falter.
Looking ahead
It was last year when we first referred to the
three downward steps we expected Western economies to journey down
as the financial crisis of 2008 unfolded. Twelve months on, it is
timely to refer back to these as we benchmark where we are on this
path and also consider how much of the journey remains. As a
reminder, the three steps were:
Step 1 - As property prices continue to fall
and personal savings rates rise, consumer demand will dissolve as
individuals focus exclusively on essentials.
Step 2 - As consumer demand deteriorates, and
with the banking sector unable or unwilling to lend, corporate
profits follow suit.
Step 3 - Rising unemployment becomes
inevitable creating renewed impetus to the global slowdown by
contracting still further consumer spending.
The epicentre of the current crisis was, and
still remains, the US housing market. Negative equity and rising
foreclosures are features of a market which must recover if US
consumers are to return to their spending ways. To illustrate the
brake applied by the average American family, borrowing dropped by
$3.2bn in May, and since December, consumer credit has dropped by
US$80bn, the biggest six-month percentage decline since the 1940s.
The zero interest rate policy applied by the Federal Reserve has
boosted mortgage affordability which should stimulate the housing
market, however, year-on-year, mortgage debt outstanding in the US
has fallen for the first time in post-War history. These numbers
illustrate the deleveraging process under way, and as we
forecasted, the US savings rate has risen sharply. We expect this
to rise further and the US housing market to remain challenging
through 2010 and into 2011.
Referring to Step 2, we have already mentioned
the continued limited access to credit due to the unwillingness of
banks to lend. Consumer demand has clearly waned. The collapse in
the volume of world trade has been worse than the first year of the
1929/34 depression as a result of the sharp decline in demand for
manufactured goods. It is no surprise corporate profits have fallen
and businesses have had to instigate aggressive discounting
strategies to maintain volumes and cut costs to boost their bottom
line. The effective bankruptcy of General Motors and Chrysler has
illustrated even discounting, combined with substantial government
assistance, has not been enough to save companies when demand for
their goods and services decline sharply. With the exception of the
banking sector, which is anomalous for obvious reasons, we are yet
to see improving economic data translate into higher earnings and
the expected, very tepid, return to economic growth is likely to
result in a very modest improvement in earnings forecasts in the
months ahead. Some industries, such as car manufacturing, may not
return to previous earnings growth levels for years to
come.
Finally, Step 3, rising unemployment has
become an unfortunate reality for too many people and their
families. For those still employed, the fear of losing their jobs
is an every day concern and there is no doubt this is a significant
headwind to consumer confidence and spending. Whilst the pace of
job losses may have started to decelerate, the numbers of
unemployed are still rising and it is estimated the number of 18 to
24 year olds out of work in the UK may be as high as 1 in 5 this
summer as school leavers and graduates enter the jobs market.
Whatever the pace and strength of the future economic recovery,
unemployment is a lagging indicator and will continue to rise
through the rest of this year and into 2010.
Conclusion
We believe the challenge that lies ahead for
us as wealth managers is positioning portfolios for a future where
high inflation is the key determinant of macroeconomic conditions,
or its opposite, deflation. The ingredients for a high inflation
world, for example, zero interest rates and the printing of money,
are clear to see and the authorities will be extremely fortunate to
withdraw this accommodative policy at just the right time to avoid
inflation. Conversely, despite all the efforts being made by
central banks and governments around the world, the deflationary
pressures caused by a lack of credit in the system, consumer
entrenchment and falling corporate profits are equally clear. The
global economy is treading a tightrope between the two and, as yet,
the future is opaque as to which of the two factors will emerge the
stronger.