Financial Management (Scotland) Ltd

January 2010

2009 was a year of deep recession. The market turmoil during January and February reflected widespread fears that the dysfunctional banking system could result in economic depression and systemic failure.

Although central banks responded by reducing interest rates effectively to zero, the availability of credit proved to be as critical as the price and it took a series of unorthodox 'quantitative easing' (QE) measures before confidence was restored.

The financial crisis triggered the largest contraction in global GDP since World War II with developed economies bearing the brunt of the downturn. After a severe contraction in the first half of the year, considerable weight was placed on one type of macro indicator - the US ISM and other manufacturing surveys - to signal the turn in the inventory cycle. Growth eventually returned in Q3 helped by targeted fiscal packages such as 'cash for clunkers'. While the US performed relatively well (GDP -2.5%) with currency weakness boosting exports, Europe (-4%) and Japan (-5%) suffered as export performance was offset by currency strength. The UK experienced the worst post-war recession on record with GDP contracting 6% from peak to trough. Consumers suffered from a weak job market, higher taxes and the reduced availability of credit.  Emerging markets (GDP +1%) also experienced a slower growth rate but, in contrast to the debt ridden developed world, their aggressive stimulus measures were aimed at underpinning growth as opposed to preventing bank failures. China and India maintained especially strong growth of 6% and 9% respectively thanks to monetary policies which boosted asset prices and did little to improve global competitiveness.

The introduction of QE and the resulting deterioration in government finances was possibly even more significant than the economic cycle. US and UK central banks had previously launched asset purchase programmes but, while these were able to boost the price of depressed assets, they withdrew liquidity from the system. In February, the Bank of England embarked on a fundamental change in monetary policy whereby it sought to control the quantity rather than simply the price of money. In a programme which was subsequently extended beyond the end of 2009, it purchased gilts in exchange for cash which was then deposited with commercial banks. The BoE 'printed' money to fund the purchases. Although a large proportion of the cash was hoarded by commercial banks as they sought to rebuild their balance sheets, the process improved market liquidity and thus confidence. Perhaps unintentionally, the fact that so little of the cash found its way into the 'real' economy helped limit the inflationary impact. However, the result of this 'debt swap' between private and public sectors was ballooning budget deficits and dangerously high levels of sovereign debt.

Aggressive policy actions ensured the financial 'bust' did not result in a deflationary spiral but the scale of the QE process heightened concerns about the inflationary repercussions. Despite the oil price recovering to $77, the lagged impact of the decline from the 2008 peak of over $140 combined with ultra-low interest rates and surplus capacity meant global inflation was just +1.9%. The US, Japan and China briefly experienced consumer price disinflation and UK RPI touched a year on year low of -1.6% in June. However, price disinflation did not affect unit labour costs which continued to rise especially in Europe - the notable exception was the US where job cuts and improved productivity kept costs in check. Surprisingly, lower industrial production did not prevent commodity prices rising by 19% (in sterling terms) as 'real assets' were hoarded by sovereign wealth funds and speculators wanting to diversify away from the dollar. Sterling was caught in the crossfire between dollar depreciation and Euro strength gaining 11% to $1.62 but losing 9% to €1.12.

Balance sheet deleveraging continued in 2009. Having been forced to step in and guarantee several major financial institutions, the authorities adopted a more conciliatory approach. This enabled banks to obtain additional equity capital and in some cases repay government facilities although several remain 'wards of court'. Tight lending criteria and higher margins helped banks raise Tier 1 capital adequacy close to 10% but long run capital ratios were still low by historic standards. The UK has proposed significant regulatory changes to introduce more stable sources of funding and reduce excessive risk taking but, in the absence of a global commitment, these could impact on London's competitiveness as a leading financial centre.

Having reached a trough in early March, the combination of policy actions and improving economic data fuelled an increased appetite for risk which propelled equity markets to their best annual return of the decade. Most developed markets produced similar gains in local currency - the FTSE 100 ended the year up 22% at 5412 - although the best returns for sterling investors came from Asia ex Japan (+54%) and emerging markets (+59%). As in 2008, share prices and corporate profits did not move in tandem with the latter falling a further 8% in the UK which meant the price/earnings valuation expanded to 15x. Dividends were down 9% as financials were forced to suspend/cut payments. The 'dash for trash' which followed the market's turning point meant small and medium sized companies outperformed large ones while mining, industrial cyclical and banks outperformed more defensive sectors. Gilts had a relatively lack lustre year as risk appetite increased with the UK 10 year yield rising 90bp to 4% while corporate bond spreads narrowed on improving liquidity and higher issuance. Hedge fund of funds are expected to achieve a return of at least 12%. Commercial property was the main alternative asset class which struggled to produce a positive return.

2010 will be a challenge for policy makers as well as investors given that a modest global economic recovery and a sharp rise in corporate profits are widely anticipated. Interest rates, bond yields and inflation are likely to start returning to 'normal' levels. The key issue is likely to be how markets respond to the withdrawal of QE and unsustainably high fiscal deficits.

Glossary

Bear Market: A market in which prices decline sharply against a background of widespread pessimism

Dow Jones: A set of indices compiled daily from New York Stock Exchange closing prices. The averages are unweighted arithmetic indices, useful for showing general price movements. The Industrial Average consists of 30 industrial stocks. Referred to as the 'Dow Jones' and is probably the most widely quoted US index.

FTSE 100: An index of the Share prices of the 100 largest companies (by market capitalisation) in the UK.

G8: The world's major financial nations –Britain, Canada, France, Germany, Italy, Japan, Russia & United States

GDP: Gross Domestic Product – A measurement of the aggregate goods produced and services provided within an economy over a year and excluding income earned outside the country. Considered one of the main yardsticks of the health and vitality of an economy. See also Gross National Product.

RPI: Retail Price Index - A monthly indication of the average price changes to a particular ‘basket’ of consumer goods, and used as a general indicator of price inflation.

S&P 500: A United States stockmarket index, maintained by Standard & Poors.

Volatility: is a statistical method that measures how much a series of values move up and down around its average. The higher the volatility number, the less consistent the historical performance has been.