Investment Review and Outlook

The cyclical case for global growth is intact

The past two years have been characterised by extreme market trends with the worst bear market in equities since the Great Depression, followed by the biggest recovery. Over much of this period, correlations have been very high across equities, credit, government bonds, currencies and commodities.

By the end of 2009, the market had transitioned to a somewhat different state. The trajectory of the recovery in equity and credit markets had flattened considerably, and the US dollar was showing some signs of recovery without causing a retracement in risk assets. The bond markets were also under pressure again, particularly at the long end, as concerns about stronger growth and supply were steepening the yield curves (to record highs in the US). These moves more than likely reflect position squaring at the end of a tumultuous year, as well as early positioning for 2010 thematics.

Some previously strong correlations may be breaking down as part of this process which is a positive development for diversification opportunities in 2010.  Nonetheless, we expect trading conditions to be typically fickle in January, as the competing themes for 2010 play out in relatively thin markets.

The strong correlation between Australian equity returns, commodity returns and the Australian dollar, since late 2007 to the end of 2009, is shown in the
graph below.

We continue to expect the cyclical case for global economic growth to prevail in the first half of 2010 including:

• extreme policy settings;
• accommodative financial conditions; and
• ongoing strength in emerging economies and the inventory cycle.
  

At the same time we acknowledge that structural negatives will remain extremely powerful and may leave the global economy vulnerable if anything goes wrong.

The inflation data is very ‘noisy’ at present. The headline inflation rate is ramping higher as extremely low commodity prices from a year ago are cycling out of the annual rate.At the same time, core inflation is quiescent at around 1% in the developed economies. In particular, inflation fears have been eased by a very low core inflation result in the US for November, underpinned by an extremely weak shelter component (which comprises about one-third of the core measure). Beyond the next couple of months, the inflation outlook appears to be benign in the major core economies for the next couple of years with deflation a bigger risk than resurgent inflation over that period. Disinflation will be underpinned by the extremely large output gaps in the key developed economies. Unusually strong commodity prices for this stage of the economic cycle will partially militate against this fall, reflecting ongoing strength in the commodity-intensive emerging economies.

Since March 2009, markets have largely normalised as extreme risk premia were priced out of many assets. One major remaining opportunity in markets appears to be the extreme steepness of yield curves (characterised by the US where the 2–10 year yield curve fleetingly reached record wides in December). The steepness of the yield curve in the US reflects the twin influences of the Federal Reserve remaining on hold for ‘an extended period’ and enormous supply putting pressure on the long end of yield curves. The fact that the first move to tighter monetary policy by key central banks (the Federal Reserve and the Bank of England) will more than likely be the cessation of quantitative easing is one reason why curves may be staying very steep for now. Ultimately, we still expect a significant flattening once the core central banks (the Federal Reserve, European Central Bank and Bank of England) start to lift cash rates.

As an aside, we also consider the steepness of the curve to be a confirming indicator of a relatively robust economic recovery – just as the inverse yield curve in 2007 was an early warning sign of recession.

The US dollar is finally showing some signs of life with a recovery which has put it back at levels that were first traded (on an index basis) in early June as shown in the following graph.

The problems in peripheral Europe together with some relatively robust data out of the US (compared with both Europe and Japan) appear to have sparked a re-assessment of the US dollar outlook. There is a reasonably strong valuation case for a stronger US dollar against the Euro and Japanese Yen. As to whether this is the start of a major up-trend in the US dollar will depend on whether the recent run of better economic data continues, and ultimately leads to a major re-appraisal of the outlook for US monetary policy. Absent from such a change in Federal Reserve policy, we suspect that the US dollar will reemerge as the favoured funding currency for carry trades.

Outlook

We remain constructive on emerging markets versus the major developed markets reflecting far superior economic fundamentals and better growth prospects. For this reason, we also favour commodity currencies where the terms of trade are likely to continue to be an important support to the economy. Finally, we generally favour equities versus bonds as the relative yields remain attractive for equities.