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Last Quarter
Market Commentary
April 2010
Although
the recovery in developed economies has been relatively modest so far,
stock markets continue to experience a 'V' shaped recovery and - despite
fears about lasting structural imbalances - the pattern is proving
remarkably similar to previous cycles.
Policy
measures combined with liquidity from central banks remain supportive
even if much of the stimulus in the developed world has been targeted on
the financial sector. Unlike increasingly indebted governments,
companies were quick to cut costs and - with the obvious exception of
banks - their strengthening financial position means corporate profits
are expected to rise 30% this year with record margins maintained and
large cash reserves built up.
So what
happens next? Clearly, withdrawing the stimulus prematurely might result
in another downward lurch but, conversely, excessive liquidity could
cause inflation to pick up. While governments in developed economies are
reluctant to bring expenditure more into line with sustainable output,
repeated stimulus reduces the long-term trend rate of economic growth
and global competitiveness. The most likely outcome is therefore
'muddling through' with the option of renewed measures in 2011 if the
recovery suffers a serious setback.
Recent
economic data has been mixed but there have been more upgrades than
downgrades to growth forecasts. Those for Asia and the US continue to
improve with Europe remaining the laggard. Overall, the 3.5% estimate
for global GDP in 2010 (2.3% for the developed world) is usefully higher
than expectations of 3% and 1.9% respectively six months ago. The
inflation outlook for the developed world is relatively benign although
there is a divergence between declining expectations for the US and an
increase for the UK. Currency rather than wages appears to be the major
influence which means that CPI and RPI in the UK will rise as a result
of the lagged impact of the 25% depreciation in trade-weighted Sterling
since mid-2007. It seems probable that the economic uptrend will
continue - perhaps even gather pace – as unemployment peaks, consumer
confidence rises and inventory destocking nears an end.
Uncertainties, however, remain – notably the liquidity cycle given the
frequent incremental reversals in policy stimulus albeit the authorities
are treading warily even in the higher growth economies. China
compensated for the global export downturn by implementing a four
pronged package encompassing monetary, credit, exchange rate and fiscal
policy but, with this starting to create growth 'problems', bank reserve
requirements have been raised and lending reined in. The latter could
still rise 15%-20% this year as part of longer term plans to invest in
infrastructure and facilitate urbanisation which raises concerns about
asset 'bubbles'. Residential property is an obvious example because if
China is to achieve an urbanisation rate similar to other developing
economy models over the next decade, this will require new housing for
an additional 200m. India, with near double-digit inflation, faces
rather different growth problems and here interest rates are rising.
Moderate growth in the developed world means that forward interest rates
have barely moved in recent months. Some emergency stimulus measures are
either expiring (Federal Reserve and Bank of England bond repurchases)
or being withdrawn (ECB repo facilities) but these moves are largely
symbolic. Overall, liquidity is declining very gradually and remains
supportive.
Another
uncertainty is the impact fiscal deterioration in the developed world
will have on funding. While attention has focused on the volume of debt,
other factors such as the private/public split, maturity profile,
currency denomination, foreign versus domestic ownership and the
proportion indexed to inflation are also important. Although there are
substantial amounts of private and public sector debt to be rolled over,
a financial crisis followed by deleveraging usually proves
disinflationary. One of the key issues is therefore the 'price' demanded
by investors and the impact this has onthe cost of capital in general.
Where there is perceived to be policy weakness - as in the case of
Greece - investors seek higher compensation so it is interesting that 10
year UK gilt yields remain at the lower end of our estimated 3.75%-4.75%
range. Companies are also active issuers of bonds but corporate spreads
– in particular on non-financials - are close to a cyclical low which
suggests that further outperformance against sovereign debt is less
likely.
There
are also tensions in currency markets - especially between the US and
China with the latter being 'accused' of refusing to allow a revaluation
of the Yuan. Currency movements in free market economies reflect an
amalgam of economic and transactional factors. During the recession, the
currencies of countries which 'printed' money (such as
the
Dollar and Sterling) experienced a relative decline in value
particularly against 'hard' commodity currencies. Now that growth is
returning and cracks have emerged in the Euro, there should be some
reversal in this trend.
Equities
are clearly no longer the bargain they were a year ago and have
anticipated much of the forecast improvement in profitability but, with
commodities again looking overextended, commercial property grappling
with funding issues and bonds marking time at best, shareholders should
be adequately rewarded for the risks. |