Monthly Investment Strategy Update - February 2009
The recession has intensified and spread, with the US unlikely to return to growth before the third quarter. This recession is set to be the worst since the Second World War. Data releases in recent weeks suggest that the recession gathered pace in the later stages of last year and has become truly global, reflecting the trade and financial market linkages that now bind the fates of nations closely together. Thanks to aggressive fiscal and monetary policy in the US – which includes the increasing use of quantitative easing – recovery should come first there. But that is unlikely to be until the third quarter of this year, at the earliest. What growth there is in the second half of the year will be driven by government, rather than the private sector. But, despite the contraction of the banking sector, the private sector should not be written off altogether, given the boost consumers are receiving from lower oil prices and mortgage rates.
Deflation concerns are set to mount, prompting further rate cuts and quantitative easing. Inflation has finally started to fall, reflecting weak growth as well as the bursting of the commodity and house price bubbles, and should turn negative in the months ahead, leading to mounting deflation concerns. For these concerns to be realised, core inflation and wage inflation would also need to turn negative. Because of the deflation threat, the major central banks should cut rates as close to zero as they dare and continue to shift towards quantitative easing – printing money to purchase assets. As these measures are largely untested, it’s not certain that they will work. , .
With mortgage rates down, the focus will shift to corporate borrowing rates. Encouragingly, however, we see initial signs of success, with US mortgage rates down to levels that have triggered refinancing activity. However, corporate borrowing rates have not fallen noticeably, and bringing them down will be a key focus for policy action in the coming weeks. So will encouraging banks to lend again: while banks’ balance sheets continue to contract, that will offset much of the monetary easing.
Corporate bonds look very undervalued... Looking at markets, we currently see most value in corporate bonds, which we estimate are priced for a higher level of defaults than in the Great Depression of the 1930s. Even against our gloomy prognosis for the economy, that looks too pessimistic.
...while equities look vulnerable in the short term, especially emerging markets. By contrast, equities, though far from expensive even measured on cyclically adjusted price-earnings ratios, are not historically cheap. So, although valuation suggests that anyone who buys and holds equities at these levels will ultimately be rewarded, there remains downside risk in the near term as markets correctly price in the risk of a depression. Emerging equity markets look particularly vulnerable in the near term. They no longer appear expensive relative to developed markets, but they don’t yet look cheap either, and history suggests that they won’t outperform until the global economy emerges from recession.
Index-linked bonds now look better value than conventionals. Another area of increasing value is index-linked bonds . In recent months, they have underperformed conventional government bonds so much that six years of outperformance has been wiped out. This reflects a combination of a sharp shift in market expectations from inflation worries to deflation concerns and a drying up of liquidity in the index-linked market. Although index-linked may well underperform further in the near term as deflation concerns intensify, they now offer better long-term value than conventional government bonds.
