|
|
By David Hudson - Chairman Asset Allocation Committee – 29 October 2008
 “Indeed, the great risk facing the global economy now is deflation in the next 12 to 24 months on the heels of a severe global recession.” What a month!Sometimes it is difficult to know where to start this monthly missive! The past month has been extraordinary in so many ways including (but not limited to):
Our take on the world is that there has been a very important transition of this crisis in the past month. A month ago, the primary concern was whether the financial system was safe. Since then, there has been an extraordinary array of public policy measures to ensure that governments are effectively standing behind the financial system. As a result, our assessment is that the system is, indeed, safe. This is the good news and it is not to be under-estimated in terms of its longer term significance. Unfortunately, at the same time as governments finally safeguarded the financial system, the real economy has clearly fallen into a synchronised recession. The most important driver of the stunning fall in equity markets in the past month has been a reassessment of the profit outlook in light of the precipitate drop in global economic activity in the past month. As a result, cyclical sectors (including the resources sector) have been hit hardest and commodity prices are falling at a breathtaking pace across the board. In addition, deleveraging continues to wreak havoc in equities, bonds, FX and commodities. The best loved positions are the worst affected in this environment. For example, emerging markets have been poleaxed in the past couple of months as their equities, currencies and bonds have all been sold aggressively. And soft commodities have given back all their gains to sit close to their lows for the past three decades. 
The other stunning adjustment has been in currency markets. In the past two months, the Japanese Yen has soared, the US dollar has made a remarkable recovery after a six-year bear market and the $A has collapsed. Some of the fall in the $A is justified by the marked deterioration in the global economy and the global economic outlook and the fall in commodity prices. But these major currency moves are also being exaggerated by deleveraging and the end of the incredibly pervasive ‘carry trade’1. The longer lasting influence of this crisis may be that the balance of payments becomes an important driver of currency markets. In a world of deleveraging and less freely available capital, companies and households have to rein in their spending and debt. This might also apply to countries as well. For decades, Australia has been running a current account deficit of up to 6% of GDP. Another way to think about the current account deficit is that it is the shortfall of national savings versus investment. And on the other side of Australia’s current account deficit is a correspondingly large capital account surplus to fund the domestic savings shortfall. In the 1980s there was a fierce debate as to whether this mattered or not. In a world of free capital flows and generally strong risk appetite supported by leverage the conclusion was that it did not. That environment is certainly changing which might mean that it is more difficult for individual countries to run large current account deficits. There is certainly a lot of focus these days on countries with high current account deficits including in the developed world the US, NZ and Australia and many developing countries in Eastern Europe including Turkey, Poland and Hungary. The major current account surplus countries, or the so-called ‘safe havens’, include Japan, Switzerland, Norway, China and Singapore. 
What does all this mean for the market outlook?The first point is that these developments open the way for dramatic interest rate cuts across the Western world as inflation concerns, which dominated central bank thinking six months ago, have disappeared. Indeed, the greater risk facing the global economy now is deflation in the next 12 to 24 months on the heels of a severe global recession. We continue to be constructive on short dated fixed income although we would readily concede a lot of easing is already priced in. We remain cautious on longer dated fixed income due to the massive increase in issuance by governments to fund various bail-outs. Nonetheless, it is hard to be outright bearish on bonds while the downside risks to global economic growth are so high. The further easing of monetary policy will provide some fillip for equity markets, which also have substantial support from extremely attractive valuations. In addition, it is also worth noting that major lows in equities are often made in October, immediately after wrenching sell-offs. And while we expect profits to be extremely disappointing in the next 12 months, much of that is already priced into equity markets. However, we still have problems with thinking that this is “the low” in equities:
Of course, this does not preclude a trading rally in equities, but we would be inclined to be wary of any such rally until we get greater clarity on the economic cycle. Credit markets are still dysfunctional, but the array of measures designed to ‘thaw’ the credit freeze are impressive and over time we expect them to be successful. High quality investment grade credit is priced for a disaster worse than anything we have seen in the past 70 years. It may still be a rough ride, but we think for long term investors it is one worth enduring particularly in financial credit where the movements have been severe and the remedial efforts by authorities have been substantial. In currency markets, we think the US dollar has made its lows after a long bear market, even though the US runs a large current account deficit. After a long bear market in the US dollar, US companies are very competitive and the trade balance has already improved substantially. The $A appears to have overshot on the downside in the near term. Just as clearly, the global economic cycle and commodity prices are likely to weigh on the currency over the next couple of years. The $A will likely have a big bounce at some point, but we would see this as more of an opportunity to sell. Finally, we would conclude by observing that we still see a large degree of complacency in Australia. We continue to think that a recession is central case in Australia. The terms of trade which has been a powerful support for the economy in the past 5 years is moving into reverse. The commodity boom has turned into a commodity bust and some cracks are appearing in the Chinese economic miracle. Indeed, given the worst credit crisis since the Great Depression and the severity of the global economic downturn we would find it amazing if the Australian economy was able to avert recession again. Time to batten down the hatches!!
|
