FYI | Feb 04 2010
By Andrew Nelson
Just a few months ago the wide array of market commentators were pretty much moving in lockstep, confident that we were on the cusp of a global recovery that would put the GFC well behind us. But as we move into the new year, and after a dismal month for stocks in January, a growing number of experts are stepping forward with more cautionary and benign forecasts for the year.
Back in the last months of 2009, the debate was about a V-shaped or W-shaped recovery and while the threat of a double dip recovery has faded, there is an increasing level of acknowledgement that the US economic rebound will be a protracted process. Not much like a V at all. Households remain a long way from being de-leveraged, fiscal stimulus is winding down, while ongoing efforts by banks to clean up their balance sheets will only prolong the current caution that many feel about the ultimate sustainability of the economic recovery.
Let’s not forget that while US banks may well have left their sub-prime losses behind, they now face the prospect of an increasing level of loan losses that are due to the severity of the recession. This fact has Russell Investments’ strategist Andrew Pease thinking a V-shaped economic rebound seems fairly unlikely. In fact, Pease thinks a V-shaped recovery could actually cause more problems than it fixes, given too fast of a recovery in the US economy could well increase concerns about the Fed’s currently easy monetary stance, which would result in higher long-term interest rates. And we know how Wall Street feels about that. It doesn’t like it one bit.
Pease believes the most likely scenario for investors is a long and deep “U”, with a prolonged move out of recession taking place while the de-leveraging process occurs. Under such a scenario of modest growth, he feels corporate profits will be able to recover in-line with expectations, while interest rates will remain accommodative, held in place by the current absence of inflationary pressure.
Pimco CEO Mohamed A. El-Erian is a little more circumspect in his assessment, in a recent commentary written for Bloomberg, El-Erian points out a significant gap between consensus market expectations and the key economic, and more importantly, the political realities in the US. And if this gap isn’t quickly bridged by the validation of the more optimistic expectations in the marketplace, he thinks there’s a real chance that investors will find January’s global equity sell-off as being the first act of a disappointing year for share markets.
2009 was a year of fairly surprising bi-partisan cooperation, with both sides of the house at least trying to work together to pull the nation out of its economic nosedive. However, each and every day sees Washington get back to business as usual, meaning the left and right are becoming increasingly polarised. With the political centre shrinking, El-Erian sees the middle as becoming more elusive. The problem is, neither the far left nor the far right command enough support to be an effective motive force on their own.
This situation isn’t helped by the quickly eroding levels of trust in key institutions, both public and private, notes El-Erian. Policy decisions are increasingly second-guessed, the banking sector’s standing in society is shaky at best, especially given President Obama’s recent attacks, while the regulatory framework is in flux, with agencies and political parties fighting for turf. Lastly, the divide between big and small is as big as El-Erian has ever seen it, while the gulf between the rich and poor continues to widen.
All this would be bad enough, but we need to keep in mind that both the US and the world, to varying degrees, are emerging from the biggest financial crisis in living memory on what are fairly unsteady legs. In the US, the GFC has not only undermined economic growth and job creation, but it has also dammed many of the streams used to put capital to productive use. This has quickly taken public debt and the US budget deficit to what we have come to acknowledge as worrisome levels.
El-Erian is particularly concerned about the surge in joblessness. Given the lack of any constructive structural measures due to increasing political deadlock, he thinks the US is staring down the barrel of a prolonged period of persistently high unemployment. This in turn increases the pressure on social welfare funding, causes general skill erosion and lower labour-market flexibility, which together will place a heavy burden on the nation’s already stretched public finances.
Together, these factors spell out a protracted post-crisis resetting of the US economy, thinks El-Erian, who points out such a view is only consistent with the academic analysis of post-crisis periods. Such research shows the extent to which massive disruptions – like the GFC of 08/09 – expose the structural cracks that can only be masked temporarily by the massive cyclical policy response we have seen.
To make things even more difficult, the US is trying to dig itself out of a deep hole at the time the batting order of global economic importance is being rearranged, with emerging economies like China, Brazil, and India now having reached the stage where they can’t be labelled “developing” with a straight face any more.
All of this evidence is overwhelming, says El-Erian, with economic and political indicators insisting on the adoption of a forward-looking structural mindset. However, markets and far too many private and public institutions still seem be held hostage by cyclical forces. Thus a more realistic assessment, thinks El-Erian, “would caution against an excessive focus on changes in growth rates at a time when absolute levels are horribly out of whack”.
Andrew Pease is equally cautious, noting that we are definitely going through a time of uncertainty. “Investors are shifting their expectations of the returns they can expect in the future. This implies significant volatility in the market this year, he warns.
Pease also thinks the run the Australian dollar has been on is at its end, noting the Aussie is now at a valuation extreme against both the US dollar and the euro. Many of the things that pushed the Australian dollar higher over the second half of last year, like the rebound in risk appetite, widening interest rate differentials and the recovery in commodity prices are now fading away.
This is especially the case with commodity stocks and prices. Australian resource stocks are priced at an average of 19 times forward earnings, he notes, but inventories are rising, while the flow of less than helpful economic news from China is also weighing. And as the last few years have shown us, weaker commodities prices tend to lead to a weaker Australian dollar.
