Fairbairn logo - go to homepage
| Home | | On-Line Demo | Which Services? | Links | FAQ's |
Search
Go

The past, present and future

Year - end review

At the start of every new year it is commonplace to reflect on the year that was and then refocus thoughts on the year to come. For investors, in many ways, this last year has been as demanding as its predecessor which, we recall only too well, saw the global financial system taken to the brink of collapse.  Based on the performance of markets during the second half of 2009, it is very easy to forget just how grave the outlook was at the turn of the year and, by March, how markets had discounted another Great Depression. Bonds were priced for ten years or more of deflation and the long run implied rate of dividend growth in equity markets was approaching zero. Investor sentiment was extremely pessimistic and economic prosperity, particularly in the West, appeared to be at risk.  The adage 'it is always darkest before the dawn' could not have applied more, as a trickle of 'less bad' economic data proved a catalyst for a very sharp recovery in confidence and risk appetite. Greater visibility over corporate earnings prompted investors to take advantage of extreme valuations and drive markets up. Although equity markets have recovered strongly, it is important to note they are still trading at levels below where they were before the financial crisis began. If it were needed, this is a telling reminder of what an extraordinary period investors have endured.

Despite investor confidence (or relief) markets have faced some tests during the final quarter of the year. Revised releases of third quarter GDP numbers in both the UK and US fell short of consensus expectations and industrial production in Western economies was generally weaker than forecast. Debt servicing problems emerged in Dubai and the credit rating agencies downgraded Greek sovereign debt and placed Spanish debt on negative watch. The fragility of the economic landscape was further evidenced by the Bank of England's decision to increase its quantitative easing programme and Ben Bernanke, the Chairman of the Federal Reserve, has considered it necessary to repeat his message that interest rates will continue to remain very accommodative until a sustainable economic recovery is underway in the US.

Notwithstanding these headwinds, the combination of better than expected corporate earnings, improving profitability and supportive monetary policy has convinced many investors and commentators alike, this 'sweet spot' for risk assets is set to persist. You will not be surprised to read our view is not quite so optimistic, albeit we do acknowledge booming new orders, very positive leading indicators and the vast pool of liquidity should prove supportive in the near term.

Looking ahead

In our previous quarterly reviews we have repeatedly listed the difficult issues and structural imbalances we see facing the global economy. These have centred on a weak banking sector, indebted governments and households in the West, a corporate sector unwilling to commit to expansive capital expenditure and the reliance on a huge policy stimulus that must, at some stage, be withdrawn. The forces behind both inflation and deflation have appeared well matched and market participants have positioned their portfolios according to which of these two forces will ultimately hold sway. Clearly both create risks for investors, however, getting this core decision correct will, we suspect, capture superior returns in 2010.

The strong performance of markets through the second half of 2009 was based on expectation - markets behaved according to type by discounting the economic recovery ahead of the event. This year, we believe, will be more about confirmation - and to assist us assess this we can consider what, as Donald Rumsfeld once famously termed, are the 'known knowns' in the global economy. We know corporate profitability has improved and companies, particularly in the US, have captured extraordinary productivity growth. There is evidence strong corporate cash positions have started to boost mergers and acquisitions activity as firms begin to focus on future growth opportunities.  Business confidence readings are supportive and financial conditions are slowly returning to the levels needed for a sustainable recovery. Central banks recognise they cannot risk tightening too early, as to do so would risk pushing the global economy back into recession. In the near term, all these factors appear to shape an environment within which risk assets are likely to make progress in the West.

As for the developing world, we have clearer visibility and it is expected to continue to attract capital as its domestic companies challenge those in the established economic powers. The superior growth rate of emerging over developed economies is set to remain, with the former accounting for more than half of global GDP in 2010 and 2011 (source: Schroders). Unless we quickly reach a situation where too much capital chases too few assets, prompting intervention by the authorities, then emerging market currencies and asset prices are also likely to rise.

This initial review provides for a very favourable outlook - but what are the risks, or to continue our Donald Rumsfeld theme, what are the 'known unknowns'? To date, there is little evidence that politicians anywhere are serious about reducing the enormous budget deficits beyond the token assurances that something will be done. A rise in government bond yields, caused by investors worrying about deficits, will potentially choke economic recovery across the Western economies, however, cuts in public spending and higher taxes will also have a detrimental effect on economic performance. These factors are strongly deflationary and it prompts us to ask how can the fiscal deficits be financed without central banks letting governments off the hook by printing money which, of course, is strongly inflationary?

Global equity markets are priced for a strong recovery with rebounds in shipping stocks, ports, logistics and materials illustrating this. They are not, currently, considered expensive, albeit a significantly higher market rating will require greater confidence in longer-term growth prospects. Strong top-line sales growth has yet to emerge and there is a risk valuations could drift back to being considered cheap and remain there for some time if the momentum of this recovery falls short of expectations we referred to earlier in this section.

This leads us finally to the 'unknown unknowns'. These could include the possibility of further financial shocks, such as a sovereign bond default or bank failure, an escalation in political or regulatory risks or significant economic disappointment. While it could seem inappropriate to suggest this, it may take one of these events, or something similar, to induce the bold policy initiatives, particularly in terms of the fiscal deficits, required to convince investors the global economy can be safely shepherded on a course to sustained recovery. Restoring this confidence will require strong leadership from governments and central bankers alike. Unpopular decisions will have to be made with some, no doubt, causing adverse short-term consequences for the voting public.