Shares Magazine - Q&A eForum
16 December 2009
1) Will the Western economies see a strong (inflationary) recovery in 2010 or remain stuck in a recessionary (deflationary) rut?
Neither, is the answer. After typical recessions, induced by an inflation, or an inventory, shock, industrialised economies usually recover quite quickly. We saw this after the 2000-01 economic slowdown in the western world, where the household sector reacted very positively – indeed with the benefit of hindsight too positively – to interest rate cuts by the central banks. On this occasion, interest rate cuts have been relatively impotent as the developed economies have mostly experienced a balance sheet recession. Yes, global economic growth will be seen in 2010, driven by infrastructure and consumer spending in the emerging economies on top of some underlying improvement in consumer spending and business investment in the OECD economies. However, the banking and household de-leveraging and the rebalancing of industrialised economies, shown by public sector debt pressures in many countries, will take several years. Trend global growth, at best, is the outlook for 2010.
2) Will risk assets (equities, commodities, even property) rise again in value in 2010?
Yes – as long as policy makers do not make any errors by tightening interest rates or withdrawing the fiscal stimulus and quantitative easing policies too quickly. The main driver will be corporate cash flow. This has been improving for several months, driven by the sizeable turnaround in the balance sheet of the corporate sectors. Strong cost control – the counterpart of the double digit unemployment rates seen in many countries – plus some improvement in top line earnings growth should lead to good earnings reports for many companies in 2010. This is positive for large parts, though not all, of the equity, corporate bond and commercial property markets. However, some assets are no longer cheap; for example some equities, such as certain emerging markets, and some assets, such as certain commodities, have priced in a considerable amount of good news. Investors should be wary!
3) How quickly (if at all) will interest rates rise in 2010 and how will that affect risk assets, particularly stock markets?
The markets are pricing in interest rate hikes next year. That does appear to be unnecessary, given our views in answer to question one, above. However, the mantra 'lower for longer' should not necessarily preclude any increase in interest rates at all, whilst still remaining at an accommodative level compared with recent history. It is not a case of expecting the moves in rates to have a noticeable impact on borrowing, lending and investment decisions – as long as central banks are merely slowly, I repeat slowly, moving rates back towards 'normal'. History suggests that initial wobbles in stock markets as this process takes place are transitory, if investors are convinced that the business cycle can be extended and will not end quickly.
4) Will the end of Quantitative Easing (QE) programmes lead to a collapse in asset prices?
Two points need to be made. Firstly, it is not inevitable that QE will end next year. Investors should remember that the Japanese have never been able totally to wean themselves off QE. If, as we believe, many of the major economies remain vulnerable next year then it may be deemed inadvisable to stop QE. The second point is that it will be important how the central banks end QE. They have been purchasing a large amount of government bonds and other assets – on some estimates the Bank of England owns over 25% of the gilt market. Do they halt such purchases and simply hold the bonds, or do they begin to sell them aggressively back into the market place? The impact on bond yields, and therefore other asset classes such as currency markets, would be rather different in either case.
5) Will cyclical and recovery stocks remain in vogue in 2010 or is it time to revisit yield stocks and defensives?
Into 2010, we expect investors will differentiate even more between countries, sectors and companies than they have in the past few months. Valuation metrics will become more important, while the withdrawal of policy stimulus and decisions over the regulatory structure of different sectors will impact on future earnings growth. Our fund managers are already examining sectors much more on a stock by stock basis, looking for stocks with quality management with sound business models able to prosper in a complex business environment. Such stocks can be found in cyclical, recovery, yield and defensive areas.
6) Will emerging equity markets and economies continue to outperform in 2010?
Given the deleveraging headwinds that developed market economies will undoubtedly face, it seems fair to say that emerging market economies will in aggregate outperform, by delivering stronger GDP growth. That said however, given the high correlation between global stock markets’ performance, that is no guarantee that emerging equity markets will outperform. In particular, one must consider that in the event of a market correction, emerging markets often underperform, given their 'higher beta' nature. For example, in 2008, emerging market equities fell by 54% in US$ terms, whilst MSCI World (developed market equities) fell by less, around 42%. This happened in a year when GDP growth in emerging markets markedly outstripped that of developed country economies.
7) What will happen to the bond markets if rates rise and QE is withdrawn?
We use our Focus on Change analysis to consider a number of drivers of bond markets. Certainly two of them are short term interest rates and decisions on QE. However, two other important ones are the short and medium term inflation trends, as well as regulatory decisions. The FSA, and its counterparts in other countries, is already encouraging commercial banks to raise the amount of gilts they hold on their own balance sheets in order to improve the structure and liquidity of their asset. In addition, output gap analysis would suggest that core inflation will remain low well into 2011, even when the economic recovery becomes well established. The net impact will be a slow upward trend in bond yields, but not too abrupt as long as central banks remain wary about undue policy tightening feeding through, for example, into still fragile housing markets.
8) Will gold and oil continue to go up?
No and not sharply. Two issues matter – the US dollar and OPEC. As the dollar improves in value – it is rather cheap on many measures – then we expect the dollar prices of gold and oil to slip back in 2010. Secondly, our analysis of OPEC and global supply and demand balances suggests that the major oil producers prefer to see oil in a $60-80 band, as this is beneficial for global economic recovery, their own fiscal positions and as a price-hindrance for the development of alternative energy sources.
9) Will the dollar continue to go down? What are the implications of this?
The dollar is undervalued against G10 currencies and is unlikely to weaken substantially from herein. Nevertheless, there will still be periods of dollar underperformance until US interest rates are on a firm uptrend. We anticipate the "lower for longer" macro theme to continue through next year but market rates will periodically begin to price in higher interest rates as economic consolidation is seen to reduce the need for policy support to such a degree. US expectations will lead those of the UK, Japan and Europe. We also see reduced investment flows into emerging markets and still low global trade volumes which will reduce central bank dollar recycling. This will lead to a weaker Euro in 2010.
10) What impact, if any, will the 2010 General Election have on UK stocks, bonds and sterling?
Given the poor state of the UK's public finances, the bond and currency markets have been rightly concerned about when, how, and how quickly, the budget deficit will be brought back into balance. Closing the deficit will require both a reduction in government spending and increases in taxes. These measures will undoubtedly prove unpopular, and will also hamper efforts to engineer a sustainable recovery in the UK economy. The key risk to being able to make these difficult decisions would be a hung-parliament. Minority governments and coalitions typically involve political bartering that makes deficit reduction more difficult. Markets may well remain nervous of the UK unless a clear election victory is delivered.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
This article was first published in Shares Magazine on 23rd December 2009.
