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Last Quarter
Market Commentary
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. |