Just over one year on from Lehman Brothers’ collapse, the world economy appears to be regaining its positive momentum and risk assets (i.e. equities, corporate credit, etc.) have performed remarkably strongly. The key equity market drivers have been risk and liquidity friendly economic policies, a robust corporate bond market, and the fact that many investors appear to be underweight equities.
Yet the story of the last quarter has not been entirely one of increasing risk. Government bond yields have fallen and gold has broken through the psychological $1000 levels – moves normally associated with increasing risk aversion. This suggests that some investors have not forgotten the events of the last year and are far from unanimous in embracing the ‘risk trade’.
The main problem that many investors face in their portfolios is that the asset class they chose late last year/early this year to protect them against the ravages of the financial crisis – cash – does not earn enough of a return anymore, while the main reason for holding cash – uncertainty – is slowly fading away. Hence, the dominant capital flow in markets this year has been the steady movement out of cash and into other better yielding assets.
All attention has now shifted to the shape of global earnings recovery. Predictions of a lacklustre economic recovery have raised fears that analysts’ consensus forecasts for 20–30% global earnings growth in both 2010 and 2011 are too ambitious.
The immediate macroeconomic backdrop is defined by strengthening economic growth, very low inflation, ultra-low short-term interest rates, private sector de-leveraging and extremely unorthodox monetary policies. Global interest rates remain at historically low levels and monetary authorities have clearly indicated that it is too early to shift towards tighter monetary policies. Investors are becoming less enamoured with cash returns and are being encouraged to move up the risk curve and into government bonds, corporate credit and, increasingly, equities.
Markets should also continue to benefit from a backdrop of earnings recovery determined by the moderation of inventory de-stocking, which will lead to some inventory re-stocking, a better (although subdued) employment environment, and the consumption benefits of some restored wealth via higher financial markets. The earnings reporting season could also surprise positively this month. The combination of a weaker dollar and a strong recovery in industrial production around the world in the last three months, implies that profit margins could be higher than forecast.
Despite gathering evidence of a recovering global economy, central bankers are sending a clear message that until they are convinced that further de-leveraging has taken place and unemployment is no longer a threat, the current stimulus will not be withdrawn. Therefore, today’s massive [OU1] policy stimulus is likely to be maintained for longer than needed as insurance against an economic relapse.
Perhaps the greatest challenge to corporate profitability will be in late 2010/early 2011 when we should have already seen a cyclical recovery in profits, but when monetary and fiscal policy are likely to be tightened.
Of course, no market moves in a straight line (up or down!) and periodic reversals are highly likely, especially with potential confusion from upcoming economic data as upward momentum slows. When things become less supportive on the economic front, risk appetite could moderate and even turn adverse. It is anticipated that investors will become more defensively oriented. In addition, future investment returns may start to re-emphasise [OU2] dividends/yield, given the substantive differential between cash returns and dividend yields. Private investors who cannot put up with any possible volatility should steer clear of equities no matter what their perception is of current market conditions.
There is every reason to expect an uneven pattern of economic data releases to emerge because rates of growth clearly accelerated sharply around mid-year and are now expected to level off. It is also highly likely that the challenge from ongoing de-leveraging in the household and financial sectors will make future growth rates lower than we have been used to. A foundation for recovery is intact, although not all the pillars are in place, and the latest economic news (particularly unemployment) provides reason to recognise the downside risk.
While it is tempting to recommend an exclusively reflation-based strategy, in light of the scale and duration of the rally to date, the rise in asset valuations and the existence of some unique upside and downside risks, a broader, slightly conservative approach is going to be most appropriate for many private investors.
NCB Stockbrokers – November 2009