The US and the UK appear to have joined the recovery in the third quarter... The global and US recessions have ended. Germany, France and Japan returned to growth in the second quarter, and business surveys suggest US and UK growth resumed in the third. The initial quarters of recovery look set to be strong, with annualised US growth of around 4% quarter on quarter. After that, the pace of growth is likely to moderate, as the headwinds of consumer de-leveraging and credit constraints assert themselves.
...as US growth forecasts for next year continue to rise. Since late April, activity numbers in the major economies have consistently beaten market forecasts. Hence, consensus expectations for 2010 US GDP growth have risen from 1.8% in March to 2.4% and are likely to rise further.
But this sort of recession is usually followed by a weak, volatile recovery. Yet there’s a limit to how far growth forecasts can rise. Although deep recessions are usually followed by strong recoveries, both credit-crunch-induced and synchronised recessions tend to be followed by weaker, more prolonged and more volatile recoveries. So not only will the economy take several years to return to pre-recession levels of activity, but it may see very strong quarters mixed with some negative ones.
Interest rates look set to stay low for some time, especially in the US and the UK. With a hesitant economic recovery and lots of excess capacity, underlying deflationary pressures will linger, slowing the normalisation of monetary policy. The US Federal Reserve won’t come under pressure to raise rates any time soon, perhaps not until 2011. And, with concerns about public finances mounting, the US and UK central banks may delay rate rises to ease the withdrawal of fiscal stimulus. The need for fiscal consolidation will remain a major concern for bond and currency markets over the next couple of years.
Can equities continue their rally? We think so. In a transition to recovery, equities and corporate bonds tend to outperform government bonds and emerging markets outstrip other equities. That has been the case in recent months, as we had expected. But, given the strong rally – especially in emerging markets – since March, can equities rise further this year? Despite longer-term concerns about equity markets as growth fades next year and the focus turns to exit strategies from ultra-stimulative fiscal and monetary policy, we think equities can advance as growth forecasts for the next couple of quarters are revised up. Equities no longer look cheap in absolute terms, but they do relative to government bonds. So, tactically, valuation still favours equities. With sentiment at elevated levels, an equity pull-back is possible in the coming weeks. But any pull-back, which could be as large as 7%, is likely to be seen as a buying opportunity.
We still prefer corporate bonds to governments and favour emerging and Asian equities over developed markets. We expect corporate bonds to keep outperforming government bonds as spreads narrow further. Spreads have come in sharply since January, when they were pricing in a rerun of the Great Depression. Nevertheless, they remain wide, giving scope for further outperformance via both yield pick-up and spread narrowing. Within equities, we still favour emerging and Asian markets. Their economies don’t face the same headwinds as the western economies – namely, consumer de-leveraging, credit constraints and the need to rebuild public finances. A global recovery led by Asian and emerging markets will support commodity prices, particularly industrial commodities and energy.
We have turned positive on UK commercial property, amid signs of stabilising prices. Having been negative on UK commercial property since July 2007, we are upgrading it to an outperform relative to cash. With yields above 8%, UK commercial property looks attractively valued. Indeed, it has for some months, but now prices are showing signs of stabilising, despite banks’ caution on lending to the sector.
