Professional Adviser – Perspectives
04 February 2010
At the start of 2010, many investors will look back on the previous year with a sigh of relief. Financial markets have recovered remarkably well from the strains and stresses of the banking crisis and the deep recession. Where next? January has been volatile so is this a time to take profits, or to put more money on the table as the bull market gathers pace? To answer such questions we must consider not only normal questions about profits, inflation and interest rates but recognise that politics will play a much more important role than usual in the coming year.
The good news is that the global recession is coming to an end, earlier in some countries such as Australia and China, later in others such as Ireland and Spain. At the start of 2009 we argued that the economic recovery would fall into three parts. Two of these have already been seen, namely the turnaround in the inventory cycle, as firms responded to the demand shock, and then the upturn in production, as companies brought supply and demand back into balance. The third step requires an expansion in consumer demand, to allow the recovery to become entrenched leading to a turnaround in business investment. Here the picture is mixed; yes, households are spending in many emerging economies. We have some good news as well in the US and France, less so in Japan and other parts of Europe, reflecting different unemployment, wage, tax and interest rate effects. Looking ahead, a key trigger for 2010 will be the upturn in employment, and therefore consumer confidence. We expect to see the turn firstly in demand for part time employees and growing use of overtime, before finally the hiring cycle turns later in 2010.
While the world economy will grow in 2010, we warn it will not be rapid. After most recessions, the first year or two normally see a sharp snap-back, say growth of 4-5% a year. This time, the headwinds from a weak financial system, tax increases and spending cuts will be rather noticeable. Hence, we expect growth of no more than 2-3% a year in the major economies. This will contrast with stronger activity in many, although not all, emerging markets. The latest Chinese data showed growth at almost 11 percent, and the IMF expects 4-6 percent in many others.
Profits will rise in 2010; the key question is can they beat analyst forecasts of 20% growth in the coming 12 months. Why so strong? The explanation is that companies have cut costs so dramatically, albeit more in the US than the UK or Europe. US business productivity jumped 10% in the past year, helped by employment falling twice as fast as in the early 1980s recession. Currency factors are positive for the UK and US, negative for Europe and Japan. Exposure to overseas markets, especially some emerging economies, matters considerably. Hence we expect considerable divergence between companies in individual sectors.
Inflation remains a problem. In the spring, headline measures will reach 3-4% a year in the Western economies, boosted by a mix of food and energy prices and consumer tax changes. Conversely, core inflation will slow further, towards 1% a year, driven by excess capacity such as 10% or so unemployment. 2010 looks set to be a year of ‘jobless recovery’, similar to the early 1990s, good for corporate profitability but bad for consumer demand.
As the authorities move away from fire fighting towards creating a new regulatory structure for the global economy, countries need to re-balance. An obvious example is how to deal with a massive public sector debt. Some of this debt is cyclical, and will improve as economies grow, but the majority is structural, reflecting the collapse in the tax base. Hence, the IMF has concluded that many OECD economies will need to tighten fiscal policy by about 1% of GDP a year, on average for five years.
Rebalancing can be seen in other ways, for example the need for the US and UK to shift resources into high value manufacturing and service sectors in order to drive exports growth. Conversely China is too dependent on exports and public sector investment and must develop a sound domestic consumer base. G20 decisions on currency movements and IMF oversight of economic policy making could be significant triggers in 2010, whether politicians are happy to leave the status quo or whether there will be sustained efforts towards global economic co-operation. Otherwise, central bankers are already warning about the risk of bubbles appearing in some emerging markets - not just China - unless action is taken
Rebalancing must happen at every level, not just government. Households and companies need to adjust, consumers must pay down debts while many companies must change their business models. The banking sector is re-balancing, as it pays more attention to building up a retail deposit base rather than relying on volatile funding from wholesale markets.
Politics will matter enormously in 2010., as the electoral cycle in the US, Japan and the UK potentially clash with rather technical issues. Obama's latest proposals, the 'Volcker rules' are different to the UK and French approach of taxing banker bonuses and increasing market competition, while various international committees are still debating a new regulatory regime for the financial sector. All in all agreement seems a long way away!
Central banks hope they can halt Quantitative Easing in the first half of 2010, and begin to raise interest rates during the second half. We would expect official rates to move up no more than 1% by year end, however, as central banks will be very wary of imitating Japan’s mistakes in the 1990s and tightening policy too abruptly. A combination of low inflation and high unemployment means interest rates should be lower for longer. By no means all such policy decisions lie with the major economies. China's latest announcements on monetary policy surprised investors, demonstrating the importance of this source of global growth, while difficult decisions on the currency lie ahead, balancing the needs of the export sector with risks of excessive inflation.
At the start of this article I asked: is this a time to take profits from the rally, or to put more money on the table as the bull market gathers pace? My answer is that this is a good time to see how the whole portfolio looks after the sharp moves in so many markets; where should it be re-balanced, taking profits in some but adding to other areas with better long term prospects. Investors must not forget the importance of always looking for value. All the points I have described in this article suggest volatile markets, so investors should be ready to step in and take advantage of some of that value when it is revealed.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
This article was first published in Professional Adviser on Thursday 4th February 2010.
