The long & winding road to recovery

Labelling the recovery with letters of the alphabet such as 'W' or 'V' is such a cliché. Song titles are far more effective. For example, the Vapors' Turning Japanese describes Japan-style deflation and Yazz's The Only Way Is Up describes a bullish 'V' shaped recovery. So, which song best describes the outlook for the world economy and markets… The Beatles' The Long & Winding Road?

Faced with considerable headwinds of reduced credit supply, corporate and consumer deleveraging, and falling house prices, GDP will remain below its long term average. The road to recovery is therefore going to be both long and winding. Indeed, the IMF noted last week that:

The global economy is beginning to pull out of a recession unprecedented in the post–World War II era, but stabilization is uneven and the recovery is expected to be sluggish. Economic growth during 2009-10 is now projected to be about ½ percentage points higher than forecast by the IMF in April, reaching 2.5 percent in 2010… the global recession is not over, and the recovery is still expected to be slow as financial institutions remain weak and credit intermediation impaired, support from public policies will gradually diminish, and households in countries that suffered asset price busts will rebuild savings.

So, although GDP growth is receiving a short term boost from fiscal and monetary stimulus and an inventory rebuilding cycle, the durability and strength of the recovery will ultimately depend on consumer spending. Since the US consumer accounts for c. 70% of GDP, US growth is likely to remain subdued until consumers save less and spend more. Furthermore, this is a global recession, which means that exports are unlikely to provide sufficient impetus to either GDP or consumption.

Equities
So, what does a prolonged period of below trend GDP mean for equity markets? Lower GDP growth implies lower earnings growth (see charts below). Therefore, P/E ratios will remain lower for longer since equity prices cannot move substantially higher unless supported by earnings growth.

Moreover, suffering from a debt hangover, management at over-leveraged companies are being distracted from growing earnings. Instead, they have to focus increasingly on reducing debt and balance sheet restructuring. Thus, companies who went into the credit crunch with robust balance sheets are likely to steal a march on their over-indebted peers. Anecdotal evidence of this includes Greene King's equity raising to buy pubs from distressed seller, Punch Taverns. In the housebuilder sector, Berkley Group learnt it's lesson from the last housing crash and went into this crash debt free, whereas Taylor Wimpey was in bad shape and returns on equity suffered…

However, even if equity prices remain stagnant for the next year, investors can still earn 5-7% p.a. in dividends, which is substantially higher than 12 month LIBOR at 1.5%. So, provided one invests in companies with sound balance sheets and dividend cover of over 2 times, the equity market is likely to be an attractive source of return.

Interest Rates
There is a limit to how high long bond yields can go while base rates are anchored at or near zero. With unemployment in the developed world converging on double figures and GDP remaining below trend, base rates will remain lower for longer. Thus, if longer yields rise too far, the carry becomes too attractive for them to rise further and institutions that can take advantage of low-cost funding from central banks will start buying, pushing yields lower.

However, this is a risky game and the stakes are high due to the many risks facing the government bond markets (QE overhang, record issuance and inflation to name but a few). Thus, in the UK at least, the yield curve has never been steeper, implying that investors are demanding a substantial risk premium over shorter yields to hold Gilts.

Inflation
As discussed previously in Inflationistas have been smoking too much 'green shoots'! inflation is being kept at bay by a wide output gap. If GDP remains below its historical average then it will take longer than average to close the output gap, postponing inflation in the process.

In conclusion, the recovery has started in earnest, but it's going to be a long and winding road to recovery. However, provided one is positioned accordingly and with realistic return assumptions, there is no reason why the road shouldn't be a profitable one.

BlackRock's Bob Doll on the outlook for equities

The following is an article written by Bob Doll and published in the FT on 3rd June 2009...

A different kind of rally

It would be an understatement to say that global equity markets have been volatile in 2009.

After sinking sharply in January and February as economic data continued to worsen and as investors grew uncertain about policymakers' next steps in combating the credit crisis, global equities went on the rise in the next couple of months and now seem to have entered a period of uncertainty.

Is the recent rally for real, or merely a blip in a longer bear market? Does it represent the start of a new bull market? Will we see less volatility from here, or should we expect the roller coaster to continue?

Since the bear market began in earnest last September (with the collapse of Lehman Brothers marking an important inflection point), several global equity rallies have failed to take hold. In our opinion, however, the rally that started in March is different. That rally (which, from trough to peak, has resulted in global price advances of more than 30 per cent) is based on a combination of technically oversold conditions, aggressive global policy actions and a general sense that the global economic recession is moving past its period of greatest weakness.

The question now is whether the rally marks the end of the bear market, or if it merely represents a temporary bounce from oversold conditions. It would be premature to suggest that a new bull market has emerged or that we have seen the end of the see-saw patterns that have been in place since last autumn.

Nevertheless, we do believe there are several important differences between current conditions and the failed rally attempts that previously occurred. From a technical perspective, this rally has been marked by strong momentum and expanding volume on the upside, and diminishing momentum and volume on the downside. Additionally, lower quality and more cyclical areas of the market have been outperforming, as have emerging markets when compared with developed markets, trends that occur when more sustained recoveries begin.

The extent to which equities are able to continue to advance will depend largely on the degree to which the global economy is able to recover. On balance, our view is that the global economy is still in the midst of a severe and dangerous recession, but, importantly, the massive policy initiatives around the world have begun to bear some fruit. The dramatic interest rate cuts, spending increases, tax cuts, capital injections, bank rescues and plethora of new government programmes have all helped to combat ongoing credit-related deflation risks.

We believe the fourth quarter of 2008 and the first quarter of 2009 will mark the low points for economic growth. We expect a small gain in world economic growth by the third quarter of this year. We also expect to see modestly positive levels of growth in the United States at some point in the second half.

While investors have grown more optimistic in recent months in the face of some "less bad" economic news, it is important to remember that less bad is not the same as actual good news. As such, we believe the rally that started in early March may be running out of steam and that a resumption of the rally will require more solid evidence of an economic recovery.

At present, we believe equities are entering a correction phase, although we believe this correction will be marked more by sideways action and less by a sharp decline. We think it is extremely unlikely that prices will retreat back to their early-March levels, but we could see some modest near-term declines and believe that continued volatility is likely. Typically, such corrections result in a give-back of between one-third to one-half of recent gains (which, in the United States, would result in a short-term drop to between 800 and 850 for the S&P 500 Index).

Over the longer term, however, we expect improving economic conditions will help equities to rise, and we believe that stocks will outperform bonds and cash over the next 12 months.

The writer is vice chairman and global chief investment officer of equities at BlackRock

Little Wing Macro: May 2009 review

The portfolio performed well in May, adding 4.5% net of costs, bringing year to date performance to 9.3%.

The majority of gains came from equity and FX, which added 2.2% and 2.6% respectively to the bottom line. Call options on Chinese and UK equities were once again the biggest contributors to performance, up 29% and 13.8% respectively. In FX, the portfolio was well positioned for dollar weakness with short USD and long gold holdings. However, the addition of Norwegian Government Bonds seemed premature as GBPNOK went through the 10.00 mark, falling 5% and costing the portfolio 0.5% on the month.

Rates also cost performance -0.4% as 10 year Gilt yields spiked 25 basis points during the month. On the plus side, short Treasury and index linked exposure offset losses with gains of 6.8% and 1.5% respectively.

A fall in portfolio volatility to sub 30% (currently 24%) allowed more cash to be deployed and cash now accounts for over 30% of assets, its lowest weight to date.

Inflationistas have been smoking too much 'green shoots'!

After the recent deflation scare, inflation expectations have normalised (see chart below of UK 10 year breakeven inflation). Nonetheless, the 'inflation-deflation' debate continues. Indeed, inflationistas such as Marc "Dr Doom" Faber would have us believe that the US is headed towards Zimbabwe-style hyperinflation!


However, while the risk of inflation has certainly increased, fuelled by monetary stimulus and rising commodity prices, to believe that inflation is about to take off requires a large leap of faith. Inflation does not just happen, it requires a transmission mechanism - usually an increase in credit supply. Increased credit supply facilitates increased demand which drives prices higher. However, given we are in a 'credit crunch', it is unlikely that the financial system will provide the transmission mechanism necessary for inflation. Moreover, until house prices trough, there is unlikely to be a recovery in the securitisation market, and therefore credit growth.


Even when the credit taps are turned back on, there is enough spare capacity to absorb increased demand and wage inflation is being kept in check by rising unemployment. Thus, with the output gap in the US at its widest since 1982, it is unlikely that inflation will make a comeback anytime soon.


Finally, if the market is pricing in inflation prematurely, then the additional 250 basis points of risk premium investors can receive by moving out of 2 year Gilts into 10 year Gilts looks extremely attractive. Indeed, the Gilt curve hasn't been this steep since 1992!

Cautious optimism

Three months into a near 40% rally in equities it is time to take stock and assess the economic outlook. Talk of a new bull market is still premature and further upside will depend on a sustained improvement in economic fundamentals and company earnings, or at least their ability to surprise on the upside.

The improvement in economic fundamentals suggests Q1 2009 marked the point of greatest weakness. Indeed, had activity continued to fall off a cliff before long we'd be back in the Stone Age!

However, despite talk of green shoots, most economic data is still negative:

Moreover, after such a sharp and synchronised cut in output, to what extent is the improvement down to restocking as opposed to a sustained demand growth? Whilst forward looking indicators such as OECD leading indicators have ticked up, measures of actual demand such as consumer spending are still in decline. Indeed, consumer demand is unlikely to improve until unemployment and the savings rate stop rising and the supply of credit increases.

Indeed, in an interview with CNN this week, US Treasury Secretary Timothy Geithner suggested consumer demand and credit supply will remain weak for some time.

"You're going to see less credit flowing, as people go back to the point when they're living within their means. That's a healthy process for the economy... But it means that you're going to see a slower recovery than what you normally see."

So, as the G8 finance ministers noted in their communiqué this week:

"There are signs of stabilization, including a recovery of stock markets, a decline in interest rate spreads, improved business and consumer confidence, but the situation remains uncertain and significant risks remain to economic and financial stability."

Bear market rally (March - May 2009) R.I.P.

It takes nerves of steel to remain in cash, on the sidelines of a 30%+ equity market rally. With every 1% that the market moves higher, the greater the temptation to join the party for fear of missing out or being proved wrong. So it is strange that the recent rally coincides with a growing consensus that large amounts of cash await a correction before being invested. Thus, in the absence of improved economic data or company earnings, the market cannot move substantially higher while this cash pile remains uninvested.

An improvement in inter-bank lending alone, as measured by the falling TED spread, is not cause for a sustained bull market. Nor is the thawing of the primary credit market. What started as a financial crisis quickly spread to the real economy with devastating effect. Therefore, the problem is wider than the banks and is not solved, but rather one important part of the puzzle (the financial system) appears to be falling into place. However, there remains a lot to be done before we can say the financial system is fixed.

Since, this recession is unlike any other in living memory, it will take even more time to fix the real economy. What makes this recession different is the almost total collapse of the financial system coupled with a synchronised global slowdown in trade and growth. This combination will make this recession more severe in terms of both length and depth than any other in recent history. Whilst the worst of GDP and financial Armageddon may be behind us, unemployment and consumer deleveraging are likely to continue to deteriorate beyond 'normal' levels, extending the duration of this slowdown in the process.

On the plus side, the extent and speed of the response matches the severity of the problem. Trillions of dollars of toxic alphabet soup (CDOs, SIVs, CDS etc.) have been replaced with equal amounts of state-funded acronymed stimulus such as TARP, TALF, APF, QE... Excessive private sector debt has been replaced with public sector debt, something of which ratings agencies are well aware. Indeed, Moody's and S&P have put the UK on negative watch and this recession will undoubtedly claim more sovereign AAA ratings.

However, while the stimulus undoubtedly made the difference between depression and recession, we have effectively borrowed from the future to pay for the present. The huge increase in money supply and public debt: GDP ratio adds its own set of risks and will lower growth in the future. In an environment of higher perceived risk, investors demand higher risk premiums.

So, expect higher bond yields and lower p/e ratios, which will increase the cost of capital and constrict economic growth. Don't be fooled by the current euphoric bear market rally.

The trend is still your friend

The chart above shows the S&P 500 from May 1960 to May 2009 using a log scale. This raises the following obervations:

1. Notwithstanding the bear market from 2000 to 2009, a clear upward trend is still in place
2. The S&P 500 is currently -2 standard deviations from the trend, which, if still in place, suggests a buy signal as the bear market is now complete, having moved from +2 to -2 standard deviations versus their long term trend
3. It is unsurprising that US equity returns have experienced a 'lost decade' given how out of line US equities were in the late 1990's (+2 standard deviations vs. long term trend)