Investment Review and Outlook

The roller coaster ride continues

The roller coaster ride that has characterised financial markets in 2010 continued in July with significant reversals in many markets. Equity markets rebounded sharply after reaching new lows for 2010 in early July. Sovereign spreads in peripheral European markets contracted sharply and other risk assets, including credit, commodities and commodity/carry currencies, recovered strongly.

Against this surge in optimism in risk assets, bond markets held in remarkably well, in part supported by the weaker economic data in the US. The US 10 year government bond had rallied from 4% in April to under 3% by late June and was essentially unchanged over July.

Finally, in a reversal of the recent trend toward a stronger US dollar (since November last year), the dollar fell significantly against all currencies including the Euro.

Risk assets were supported by a number of factors including:

• Another stellar reporting season in the US, with generally positive guidance providing some reassurance that the recent run of weak US economic data is not necessarilythe harbinger of a double dip.
• Valuations continue to be a significant support for equity markets, which have effectively been substantially de-rated this year against a backdrop of strong profit growth and falling bond yields.
• Greater optimism about a soft landing in China helped by a rebound in base metals and spot iron ore prices and a very benign inflation reading for the month of June. The latter makes a policy mistake by the Chinese authorities less likely.
• Oversold conditions in markets following a 17% peak to trough drop in the S&P 500 by early July which created high levels of fear illustrated by elevated equity market volatility for over two months from early May until early July.
• Late in the month, the much anticipated European bank stress test increased the transparency of bank balance sheets (even if the ‘stress’ scenarios were widely considered to be too benign). While the long term structural issues in Europe remain deeply troubling, it appears that the European sovereign debt/ banking/ currency crisis is over, at least for now.

As we pointed out last month, a reasonable case can be made for a continuation of the recovery in risk assets over the balance of this year. The global economy is expanding, liquidity conditions are generally very supportive and equity valuations are fair in absolute terms and very cheap relative to interest rates.

Persistent fears of a ‘double dip’ in economic growth (in the US in particular), has been the major impediment to such a recovery. While the recent positive surprises in Europe are obviously welcome, our view is that Europe would not be able to sustain even a modest economic upswing without a US economic recovery, given the fiscal consolidation planned for the coming years and the already low potential growth rate. The emerging economies have a much greater potential to de-couple, but a relapse in the US economy (and developed economies generally) would obviously be a major setback for these economies as well.

As usual, it comes down to the US economic outlook and in the words of the Chairman of the US Federal Reserve, Ben Bernanke, in his semi-annual testimony to Congress in July, it is ‘unusually uncertain’. Aside from the growth induced by a massive fiscal stimulus and the usual inventory cycle, the US economic recovery has been tepid at best. These growth supports will be absent in the second half of 2010. Furthermore, fiscal policy will be an outright drag on growth in 2011.

At the same time, the pulse of private final demand (consumption and business investment) appears to be weakening. Consequently, the ‘hand-off’ of economic growth from the fiscal stimulus/ inventory cycle to private final demand appears to be at some risk of failing. The resolution of these uncertainties will tell the tale of the second half of this year.

If the US (and global) economy does disappoint in the second half, the policy levers available to respond are extremely limited. Policy interest rates in the major developed economies are already zero to 1% and there is considerable and justified angst about the sustainability of government debt in these economies which will limit any fiscal response to renewed weakness in growth. The major policy which can still be employed is a resumption of the quantitative easing program.

That is why, as noted earlier, bond markets performed well as growth expectations were marked down leading to speculation that the US Federal Reserve might resume the buying program under its quantitative easing policy. The yield curve flattened aggressively, particularly out to five years as markets continue aggressively to reduce expectations of monetary policy tightening in coming years.

Outlook

The outlook appears quite binary. If the US economy keeps growing, risk assets can sustain a recovery in the second half and government bond yields could be expected to move higher. Alternatively, the US economy double dips dragging much of the developed world down with it and limiting the growth in the developing economies. Risk assets would remain under pressure and government bond yields can fall much further.

We favour the former scenario but are wary of the latter particularly as there is, once again, a lack of available diversifying portfolio themes in the market at present. It remains most likely that this fall in risk assets is corrective rather than the start of a new bear market, but after such a long rally with minimal corrections it is possible that this consolidation phase lasts for several months.