Investment Perspective

October 2009 - From financial crisis to fiscal crisis?

WITH ECONOMIES EMERGING FROM RECESSION AND STOCK MARKETS RALLYING STRONGLY, THE FINANCIAL CLIMATE HAS IMPROVED MARKEDLY. YET THE RECOVERY REMAINS FRAGILE, AND POLICY-MAKERS FACE A STRUGGLE TO RESTORE THEIR FISCAL POSITIONS.

When the credit-fuelled global property bubble started to deflate in the summer of 2006, it led to a financial crisis that wiped trillions of dollars off the value of property and financial assets. It also brought the global financial system to its knees, as banks became insolvent, credit markets froze and liquidity dried up. This, in turn, sent an already-faltering global economy into a tailspin that threatened to bring world trade and industrial production to a standstill.

The spread of the crisis from financial markets into the real economy threatened a deep depression. That prompted a concerted policy response from G-20 finance ministers and heads of state in order to stabilise the financial system and restart the global economy. The measures have led to a large rise in government deficits and debt-to-GDP ratios as risk was transferred from the private sector balance sheet to the public sector. Now, many of those governments have to produce plans for fiscal consolidation in the medium term if they are to curb any upward pressure on their long-term interest rates and downward pressure on their currencies.

Almost three and a half years on from the start of this crisis, the global economy has emerged from a brutal recession, in which the US economy contracted by 4%. The global economy is expanding again, pulled out of recession by the strong performance of Asia and by stabilisation or modest recovery elsewhere. In the advanced economies, unprecedented public intervention has stabilised activity and has even returned several countries to modest growth. Emerging and developed economies are generally further ahead on the road to recovery, led by a resurgent Asia. However, the pace of recovery is slow, and activity remains far below pre-crisis levels. The pick up is being driven by a rebound in manufacturing and a turn in the inventory cycle, and there are some signs of gradually stabilising retail sales, returning consumer confidence and firmer housing markets.

The trigger for this rebound was a strong policy response from the G-20, which supported demand and all but eliminated fears of a global depression. These fears contributed to the steepest drop in global activity and trade since the Second World War. Central banks reacted with exceptionally large cuts to interest rates, as well as unconventional measures to inject liquidity and sustain credit. Governments launched major fiscal stimulus programmes while supporting banks with guarantees and capital injections. Together, these measures reduced uncertainty and increased confidence, fostering an improvement in financial conditions.

INVESTMENT REVIEW

• The global economy has emerged from a severe recession, thanks to an unprecedented policy response from the G-20 nations and a resumption of strong growth in China..
• Growth, though positive, remains weak and is therefore vulnerable, especially to any premature tightening of fiscal policy or renewed instability in the financial system.
• Despite these threats, this phase of the economic cycle should still be positive for riskier assets, such as equities, corporate bonds and most commodities.
• Within equities, we favour Europe, the Far East and emerging markets, and we also see opportunities in small-cap stocks, at least in the short term.

           
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