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By David Hudson - Chairman Asset Allocation Committee – 29 October 2008
 The bear market in credit is 16 months old and the bear market in equities is coming up for its 12 month anniversary. In that time the wealth destruction has been devastating particularly for those investors exposed to investments dependent on leverage. During September, the credit crisis deepened to the point where iconic financial institutions fell by the way side at an alarming rate. In less than a month, Fannie Mae, Freddie Mac, Lehmans, AIG, Merrill Lynch, Washington Mutual, HBOS and Bradford and Bingley all had a change of ownership in one way or another or went out of business altogether. And the last month has continued to be extraordinary in so many ways including (but not limited to):
Our take on the world is that there has been a very important transition of this crisis in the past month. A month ago, the primary concern was whether the financial system was safe. Since then, there has been an extraordinary array of public policy measures to ensure that governments are effectively standing behind the financial system. As a result, our assessment is that the system is, indeed, safe. This is the good news and it is not to be underestimated in terms of its longer term significance. Unfortunately, at the same time as governments finally safeguarded the financial system, the real economy has clearly fallen into a synchronised recession. The most important driver of the stunning fall in equity markets in the past month has been a reassessment of the profit outlook in light of the precipitate drop in global economic activity in the past month. As a result, cyclical sectors (including the resources sector) have been hit hardest and commodity prices are falling at a breathtaking pace across the board. In addition, deleveraging continues to wreak havoc in equities, bonds, FX and commodities. The best loved positions are the worst affected in this environment. For example, emerging markets have been poleaxed in the past couple of months as their equities, currencies and bonds have all been sold aggressively. And soft commodities have given back all their gains to sit close to their lows for the past three decades. The other stunning adjustment has been in currency markets. In the past two months, the Japanese Yen has soared, the US dollar has made a remarkable recovery after a six-year bear market and the $A has collapsed. Some of the fall in the $A is justified by the marked deterioration in the global economy and the global economic outlook and the fall in commodity prices. But these major currency moves are also being exaggerated by deleveraging and the end of the incredibly pervasive ‘carry trade’1. 
The longer lasting influence of this crisis may be that the balance of payments becomes an important driver of currency markets. In a world of deleveraging and less freely available capital, companies and households have to rein in their spending and debt. This might also apply to countries as well. What does this all mean for the market outlook?The first point is that these developments open the way for dramatic interest rate cuts across the Western world as inflation concerns, which dominated central bank thinking six months ago, have disappeared. Indeed, the greater risk facing the global economy now is deflation in the next 12 to 24 months on the heels of a severe global recession. The further easing of monetary policy will provide some fillip for equity markets, which also have substantial support from extremely attractive valuations. In addition, it is also worth noting that major lows in equities are often made in October, immediately after wrenching sell-offs. And while we expect profits to be extremely disappointing in the next 12 months, much of that is already priced into equity markets. Credit markets are still dysfunctional, but the array of measures designed to ‘thaw’ the credit freeze are impressive and over time we expect them to be successful. High quality investment grade credit is priced for a disaster worse than anything we have seen in the past 70 years. It may still be a rough ride, but we think for long term investors it is one worth enduring particularly in financial credit where the movements have been severe and the remedial efforts by authorities have been substantial. In currency markets, we think the US dollar has made its lows after a long bear market, even though the US runs a large current account deficit. After a long bear market in the US dollar, US companies are very competitive and the trade balance has already improved substantially. The $A appears to have overshot on the downside in the near term. Just as clearly, the global economic cycle and commodity prices are likely to weigh on the currency over the next couple of years. The $A will likely have a big bounce at some point, but we would see this as more of an opportunity to sell. Finally, we would conclude by observing that we still see a large degree of complacency in Australia. We continue to think that a recession is central case in Australia. The terms of trade which has been a powerful support for the economy in the past 5 years is moving into reverse. The commodity boom has turned into a commodity bust and some cracks are appearing in the Chinese economic miracle. Indeed, given the worst credit crisis since the Great Depression and the severity of the global economic downturn we would find it amazing if the Australian economy was able to avert recession again. 1. Investors in the carry trade buy high yielding currencies (recently these include the $A, $NZ and Brazilian Real) and sell low yielding currencies (recently the Japanese Yen, Swiss Franc and $US).
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