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Global Markets Weekly - 16th March 2009

• Risk assets rallied, despite poor data, particularly from Germany...
  Last week’s rally in risk assets, though welcome, can't be explained by developments in the real economy. Data releases in aggregate continue to come in weaker than analysts’ expectations, particularly the German industrial production and orders numbers. Total industrial production is now 20% lower than a year ago, and export orders of capital goods, until recently a mainstay of German growth robustness, are 48% down on a year ago.
• ...which, along with Japan, is suffering from a high exchange rate.
  The high export exposure of German and Japanese manufacturers is proving a disadvantage amid rapidly declining global trade volumes. Europe and Japan also face the drawback of exchange rates that are 22% and 20% respectively stronger versus the dollar than at the time of the last recession, in 2001.
• Companies can't cut costs as fast as orders are shrinking.
  Disappointing production growth will affect companies’ earnings through reduced volumes and, less directly, via increases in unit labour costs. As order books shrink unexpectedly fast, companies cannot keep up in their efforts to control costs. As a result, unit labour costs have risen in most developed economies.
• The rally seems to be driven by more realism on the earnings outlook...
  So, rather than an economic improvement, last week’s rally can be mainly attributed to the fact that this bad news for earnings is now more acknowledged by equity analysts , and discounted into equity prices, than at any time since the recession began. Forward earnings expectations for the S&P 500 are now 35% below their trend rate of growth, compared with 18% and 12% in the previous two US recessions.
• ... and by valuations.
  Corroborating valuation’s role in the rally, the strongest rallies have come mainly in the markets that have sold off most since their peaks in the third quarter of 2007 . This is true for developed relative to emerging markets. It’s also the case within emerging market regions, where the worst peak-to-trough move in dollar terms was in Eastern Europe. This index is now 14% above its 2nd March trough.
• China and Korea both hinted at further fiscal loosening...
  Asian sentiment was buoyed by announcements from China and Korea which pointed to further fiscal stimulus . Chinese Premier Wen Jiabao, though avoiding any explicit commitments, referred to ‘contingency plans to handle greater difficulties’. Officials in South Korea indicated that a supplementary budget worth around $20 billion (2.3% of GDP) was likely to be announced over the coming weeks.
• ...while the UK started its QE, with Switzerland set to follow.
  In Europe, the main policy developments came from non-euro countries . The Bank of England initiated quantitative easing (QE) measures in the gilts market. The Swiss National Bank (SNB) cut interest rates to a ‘minimum level’ of 0.25% and indicated that it too would undertake QE. It also intervened to weaken the Swiss franc, mainly through buying euros.
• Will the Japanese likewise seek to weaken the yen?
  As we have noted before, if all major economies are quantitatively easing, that is effectively a competitive devaluation regime. The SNB’s action makes this link clear. If the European Central Bank implements QE measures (creating euros), a continuation of current SNB policy would mitigate its impact (by buying and hoarding euros). Japan has so far acceded to US pressure not to intervene to weaken the yen. Presumably, however, Japanese politicians will have a pain threshold in terms of trade and production declines at which the policy is resurrected.
• Concerted policy action is needed to revive growth.
  So, although the recent equity rally is welcome, we still await a coordinated policy framework that will lead the global economy out of its predicament. In the meantime, it is sensible to remain cautious .

Indices, Interest rates and Inflation

View the full Global Markets Weekly report (pdf).

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