The world is in recession
The best thing about 2008 for most investors is that it is over. Global equity markets had their worst financial performance in decades while US treasuries, UK gilts and German bunds rallied, benefiting from their safe haven status. Growth forecasts...
The best thing about 2008 for most investors is that it is over. Global equity markets had their worst financial performance in decades while US treasuries, UK gilts and German bunds rallied, benefiting from their safe haven status. Growth forecasts for economies across the globe have been slashed lower. The only silver lining that can be drawn from the current economic scenario is that inflation is expected to keep dropping. But hold your horses before cheering too much, as a prolonged period of very low inflation (or disinflation) may be even more devastating.
A sustained period of general price decreases can hurt the economy in two major ways. First it can encourage consumers to postpone their purchases: Why buy something today when you know you could get it cheaper tomorrow? The second negative effect is that debt becomes more expensive in real terms. For this particular reason, countries with very low savings rates like the United Kingdom and the United States may be facing a significant risk.
Most of the action in 2008 occurred in the second half of the year, where most developed economies officially fell into a recession. In economics, a general definition of a recession is described as two successive quarters of negative growth (Gross Domestic Product). To combat such a gloomy economic environment, central banks have embarked on a path of easing monetary policy. As the first major economy to have show-cased symptoms of severe economic downturn, the US was also the most proactive when it came to using its monetary arsenal to help the economy. To this extent, the US Fed funds rate stood at virtually zero per cent as at the time of writing.
The euro area economy was the first major economy to officially announce that the economic area was in recession. Nonetheless, the pace of contraction fared better than that of other major economies. This was also reflected in the monetary policy stance taken by the European Central Bank, where although it did lower rates in concert with other central banks, the rate cuts affected were much less aggressive. However, the decisions taken by the ECB are still attracting some criticism, as an increasing number of economic pundits hold that Mr Trichet & Co. are behind what is already being priced in by the market. The ECB is not new in defying market expectation after last July's surprise hike in interest rates.
Will the ECB think-thank flout the market's belief for a second time? In current market environment it seems unlikely that the ECB will hold back in further assisting ailing economies. Additionally inflationary concerns have waned significantly thereby leaving further room for downward manoeuvre in rates. This is the first real test for the relatively young Monetary Union. The belated economic Noble prize winner, Milton Friedman was of the view that a European unified monetary area would succumb to the first serious global recession. Nonetheless, before leaving the world for greener pastures in November 2006, the economist also stated that he was indeed surprised by the discipline with which member countries were abiding to the regulations set, and the overall success of the euro since its inception.
Of particular concern within the euro-area are the so-called "PIIGS", that is Portugal, Ireland, Italy, Greece and Spain. If the above-mentioned countries still held the autonomy on their country's monetary policy, they would have probably been much more aggressive with regards to rate cuts when compared to the actual decisions taken by the ECB. Additionally, the dead and buried escudo, Irish punt, Italian lira, drachma and the peseta would have most probably suffered severe downward pressure (although some level of depreciation might have been beneficial to stimulate exports). The monetary policy in the euro area most of the time mirrors the economic situation in its larger players, especially Germany. The economic divergence between euro-area economies could result in acute problems for the "PIIGS" economies as already highlighted in a number of reviews from credit rating agencies.
Developing economies which were the steam in the engine for global growth during the past couple of years were anything but isolated from the economic downturn. After a number of years with double digit growth, China's era of hyper-growth is coming to a rather disruptive end. 2008's GDP forecast is set to come in at slightly above the nine per cent level mark, but economists' forecast for 2009 is being set below eight per cent. On a more positive note, China and a number of other emerging markets are entering this protracted period of economic downturn in a much better financial position with significant amounts of financial reserves.
The base case scenario put forward by most analysts for 2008 was that of a moderate economic slowdown to a slight period of recession. A fully fledged recession is what we currently have on the decks! Such a severe outlay was unforeseen by most market participants. But we need not be all doom and gloom, there is still light at the end of the tunnel and investment opportunities will lay ahead in a nonetheless painful route to recovery.
Bonds - possibilities of equity-like returns
Developed countries government bonds have performed exceptionally well, with yields currently near an-all time low, while corporate bonds in general posted one of the worst years on record, with yields hovering at multi-year high. Credit spreads have experienced unprecedented volatility after years of compression. Default rates are expected to reach low double digit figures according to credit rating agency Moody's. Default rates are likely to exceed the peaks of 1991 and 2002, when they topped 11.9 per cent and 10.4 per cent, respectively. The reason for this, according to the Agency, is that economic conditions are already substantially weaker than in the past two credit cycles. In such a base case scenario investors should once again focus on good quality bonds and be very selective in their allocations.
Governments look determined to anchor sovereign bond yields at or below current low levels, so to induce prospective investors to riskier assets and hopefully restoring confidence and liquidity. The major risk to a peaking bond market is deflation, a word that has been hitting media wires very often lately. Should global economies emulate the Japanese deflationary period that impended on the Asian economy over the last decade, interest rates may remain grounded at the current low levels for some time. Bond convexity characteristics state that any slight movement in bond yields when yields are already relatively low, should bring about significant moves in bond prices. This implies that at the current low level of government bond yields, any small change in yield can result in a much larger change in the bond price.
In the short term, given the current unfavourable economic scenario, yields are expected to stay at or even below current levels. So before liquidating any high-performing government stocks, one must make sure that there are convincing signals that global financial markets are moving back to normality. As things stand now the probability of deflation and an extended recession looks more imminent than that of a recovery.
Credit markets have been struggling to keep afloat since the fall of Lehman Brothers and the bout of forced mergers and nationalisations. This resulted in credit spreads trading at attractive levels in historical terms. But the possibility of some further widening in the short term is still looming. With the current yields, corporate bonds may be ideal for those investors who are usually accustomed to invest in equities for the longer term, but without the same acute level of volatility. Even so, emphasis should be laid on good quality bonds as non-investment grade bonds will find it very challenging to refinance debt in the coming years. The key factor to look out for in bond issuers will be leverage. Investors should focus on companies with low levels of debt in relation to equity.
Equities - blurred earnings projections
After five happy years of lucrative returns, equity markets plunged into the doldrums with most markets trading at or below the 2001 levels. Developed equity markets dropped between 30 to nearly 50 per cent in 2008, with emerging markets faring at the upper end of this range. The 2007 best performing sector, that is, the commodities' sector, was 2008's main laggard. The financial sector was also one of the main culprits after it was resuscitated by governments for several times during 2008. Investors' lure for equities suffered a brutal knock out during the past year and it will take some time before confidence in such an asset class is restored.
This downfall in equity prices has made conventional valuations look relatively cheap based on historical averages but on the other hand, visibility of future earnings currently looks very blurred.
A characteristic that will re-feature this year is volatility, which if anything will make earnings projection ever more challenging. Things may get worst for the equity markets before they actually get better.
Investors opting to selectively start rebuilding their equity portion of their portfolios should do so in relatively small chunks and with a relatively longer term perspective than previous years. Should this period of uncertainty and negative earnings extend through 2010, defensive sectors like Telecoms and Healthcare are expected to relatively outperform while cyclical sectors like commodities and consumer discretionary goods may wobble further into negative territory. If we take on a more positive base case scenario where economies start recovering in the last quarter of 2009, sectors like financials and technology should be among the early beneficiaries.
With respect to regional allocation, investors should focus on countries well embarked on expansionary fiscal policies and proactive monetary policy missions. Emerging market equities have suffered sizable outflows for 2008. The drop in demand for commodities and heightened risk aversion do not bode well for equities in developing econo-mies in 2009. Asian export-oriented economies are also expected to experience a lack of demand from developed economies.
Currencies - testing the euro
2008 was a year of reversals for the currency markets, with 2007's depreciating dollar gaining ground against a broad based number of currencies, as risk-averse investors found shelter in the greenback. The Japanese yen and the Chinese yuan were the only two currencies that appreciated against the US dollar.
Another dominant theme was the unwinding of the so-called carry trades. A carry trade consists of borrowing in a low-yielding currency (like the Japanese yen) and investing those funds in a high-yielding currency (like the Australian dollar). Such a trade would be profitable if the low yielding currency did not appreciate. But as extreme risk aversion emerged, such carry trades were soon being reversed, leaving currencies like the Australian dollar with a loss of approximately 35 per cent versus the Japanese yen at year end.
The British pound was another laggard over the year, trading at all-time lows versus the euro as the currencies flirted at parity level. Should the prospects for global economies improve, dismal performers like the sterling would result among the main beneficiaries, while the dollar would be expected to lose further ground as risk avoidance falters. Possible dollar depreciation may be accompanied by some euro appreciation if the euro-area does not fall into a protracted period of recession or the ECB keeps on dragging its feet on lowering interest rates.
The euro may suffer further selling pressure versus the sterling given the slower pace with which the ECB is lowering rates when compared to its British counterpart. Low commodity prices and waning global demand should cap any upside potential for emerging market currencies.
Commodities - suffering from waning global demand
After a very strong first half in 2008 with soaring commodity prices at or near all-time high, prices had to succumb to global economic weakness. After sky rocketing to an all-time high of $147.27 per barrel in July, the price of oil plummeted to $35 per barrel late in December. Short term upside potential should be capped by lower global demand; nonetheless analysts' projections from a medium-to long-term perspective are still well above current market prices. On the other hand, gold lived up to expectations as it delivered a stable performance over the year. In absolute terms the price registered no significant move but in relative terms it outperformed most asset classes. In the short term prices are expected to move sideways but the possibility of dollar depreciation and the resurface of inflation in the medium term could heave the precious metal to higher levels.
The outlook for base metals is expected to be re-tested to the downside in the coming year given the sector's strong correlation to global GDP.
The agricultural sector was not immune to the market turmoil even though the sector is not highly leveraged and analysts' are still relatively optimistic on a medium-to long-term perspective.
Any upward movements are likely to be supply side driven (supply shortages and disruptions) rather than demand.
• The information and opinions were prepared by the Research & Analysis Unit, Bank of Valletta plc (BOV). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. BOV makes no representation as to the accuracy or completeness of such information. BOV has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. BOV shall not be liable for any decision made or taken in reliance on such information. This report is provided for informational purposes only.
It is recommended that if an interested person requires investment advice or wishes to discuss the suitability of any investment decision, s/he should seek financial, legal or tax advice from his/her professional advisers as appropriate. Income from an investment may fluctuate and the price or value of financial instrument, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results.
• The author is an investment analyst at Bank of Valletta plc.
kevin.polidano@bov.com
A sustained period of general price decreases can hurt the economy in two major ways. First it can encourage consumers to postpone their purchases: Why buy something today when you know you could get it cheaper tomorrow? The second negative effect is that debt becomes more expensive in real terms. For this particular reason, countries with very low savings rates like the United Kingdom and the United States may be facing a significant risk.
Most of the action in 2008 occurred in the second half of the year, where most developed economies officially fell into a recession. In economics, a general definition of a recession is described as two successive quarters of negative growth (Gross Domestic Product). To combat such a gloomy economic environment, central banks have embarked on a path of easing monetary policy. As the first major economy to have show-cased symptoms of severe economic downturn, the US was also the most proactive when it came to using its monetary arsenal to help the economy. To this extent, the US Fed funds rate stood at virtually zero per cent as at the time of writing.
The euro area economy was the first major economy to officially announce that the economic area was in recession. Nonetheless, the pace of contraction fared better than that of other major economies. This was also reflected in the monetary policy stance taken by the European Central Bank, where although it did lower rates in concert with other central banks, the rate cuts affected were much less aggressive. However, the decisions taken by the ECB are still attracting some criticism, as an increasing number of economic pundits hold that Mr Trichet & Co. are behind what is already being priced in by the market. The ECB is not new in defying market expectation after last July's surprise hike in interest rates.
Will the ECB think-thank flout the market's belief for a second time? In current market environment it seems unlikely that the ECB will hold back in further assisting ailing economies. Additionally inflationary concerns have waned significantly thereby leaving further room for downward manoeuvre in rates. This is the first real test for the relatively young Monetary Union. The belated economic Noble prize winner, Milton Friedman was of the view that a European unified monetary area would succumb to the first serious global recession. Nonetheless, before leaving the world for greener pastures in November 2006, the economist also stated that he was indeed surprised by the discipline with which member countries were abiding to the regulations set, and the overall success of the euro since its inception.
Of particular concern within the euro-area are the so-called "PIIGS", that is Portugal, Ireland, Italy, Greece and Spain. If the above-mentioned countries still held the autonomy on their country's monetary policy, they would have probably been much more aggressive with regards to rate cuts when compared to the actual decisions taken by the ECB. Additionally, the dead and buried escudo, Irish punt, Italian lira, drachma and the peseta would have most probably suffered severe downward pressure (although some level of depreciation might have been beneficial to stimulate exports). The monetary policy in the euro area most of the time mirrors the economic situation in its larger players, especially Germany. The economic divergence between euro-area economies could result in acute problems for the "PIIGS" economies as already highlighted in a number of reviews from credit rating agencies.
Developing economies which were the steam in the engine for global growth during the past couple of years were anything but isolated from the economic downturn. After a number of years with double digit growth, China's era of hyper-growth is coming to a rather disruptive end. 2008's GDP forecast is set to come in at slightly above the nine per cent level mark, but economists' forecast for 2009 is being set below eight per cent. On a more positive note, China and a number of other emerging markets are entering this protracted period of economic downturn in a much better financial position with significant amounts of financial reserves.
The base case scenario put forward by most analysts for 2008 was that of a moderate economic slowdown to a slight period of recession. A fully fledged recession is what we currently have on the decks! Such a severe outlay was unforeseen by most market participants. But we need not be all doom and gloom, there is still light at the end of the tunnel and investment opportunities will lay ahead in a nonetheless painful route to recovery.
Bonds - possibilities of equity-like returns
Developed countries government bonds have performed exceptionally well, with yields currently near an-all time low, while corporate bonds in general posted one of the worst years on record, with yields hovering at multi-year high. Credit spreads have experienced unprecedented volatility after years of compression. Default rates are expected to reach low double digit figures according to credit rating agency Moody's. Default rates are likely to exceed the peaks of 1991 and 2002, when they topped 11.9 per cent and 10.4 per cent, respectively. The reason for this, according to the Agency, is that economic conditions are already substantially weaker than in the past two credit cycles. In such a base case scenario investors should once again focus on good quality bonds and be very selective in their allocations.
Governments look determined to anchor sovereign bond yields at or below current low levels, so to induce prospective investors to riskier assets and hopefully restoring confidence and liquidity. The major risk to a peaking bond market is deflation, a word that has been hitting media wires very often lately. Should global economies emulate the Japanese deflationary period that impended on the Asian economy over the last decade, interest rates may remain grounded at the current low levels for some time. Bond convexity characteristics state that any slight movement in bond yields when yields are already relatively low, should bring about significant moves in bond prices. This implies that at the current low level of government bond yields, any small change in yield can result in a much larger change in the bond price.
In the short term, given the current unfavourable economic scenario, yields are expected to stay at or even below current levels. So before liquidating any high-performing government stocks, one must make sure that there are convincing signals that global financial markets are moving back to normality. As things stand now the probability of deflation and an extended recession looks more imminent than that of a recovery.
Credit markets have been struggling to keep afloat since the fall of Lehman Brothers and the bout of forced mergers and nationalisations. This resulted in credit spreads trading at attractive levels in historical terms. But the possibility of some further widening in the short term is still looming. With the current yields, corporate bonds may be ideal for those investors who are usually accustomed to invest in equities for the longer term, but without the same acute level of volatility. Even so, emphasis should be laid on good quality bonds as non-investment grade bonds will find it very challenging to refinance debt in the coming years. The key factor to look out for in bond issuers will be leverage. Investors should focus on companies with low levels of debt in relation to equity.
Equities - blurred earnings projections
After five happy years of lucrative returns, equity markets plunged into the doldrums with most markets trading at or below the 2001 levels. Developed equity markets dropped between 30 to nearly 50 per cent in 2008, with emerging markets faring at the upper end of this range. The 2007 best performing sector, that is, the commodities' sector, was 2008's main laggard. The financial sector was also one of the main culprits after it was resuscitated by governments for several times during 2008. Investors' lure for equities suffered a brutal knock out during the past year and it will take some time before confidence in such an asset class is restored.
This downfall in equity prices has made conventional valuations look relatively cheap based on historical averages but on the other hand, visibility of future earnings currently looks very blurred.
A characteristic that will re-feature this year is volatility, which if anything will make earnings projection ever more challenging. Things may get worst for the equity markets before they actually get better.
Investors opting to selectively start rebuilding their equity portion of their portfolios should do so in relatively small chunks and with a relatively longer term perspective than previous years. Should this period of uncertainty and negative earnings extend through 2010, defensive sectors like Telecoms and Healthcare are expected to relatively outperform while cyclical sectors like commodities and consumer discretionary goods may wobble further into negative territory. If we take on a more positive base case scenario where economies start recovering in the last quarter of 2009, sectors like financials and technology should be among the early beneficiaries.
With respect to regional allocation, investors should focus on countries well embarked on expansionary fiscal policies and proactive monetary policy missions. Emerging market equities have suffered sizable outflows for 2008. The drop in demand for commodities and heightened risk aversion do not bode well for equities in developing econo-mies in 2009. Asian export-oriented economies are also expected to experience a lack of demand from developed economies.
Currencies - testing the euro
2008 was a year of reversals for the currency markets, with 2007's depreciating dollar gaining ground against a broad based number of currencies, as risk-averse investors found shelter in the greenback. The Japanese yen and the Chinese yuan were the only two currencies that appreciated against the US dollar.
Another dominant theme was the unwinding of the so-called carry trades. A carry trade consists of borrowing in a low-yielding currency (like the Japanese yen) and investing those funds in a high-yielding currency (like the Australian dollar). Such a trade would be profitable if the low yielding currency did not appreciate. But as extreme risk aversion emerged, such carry trades were soon being reversed, leaving currencies like the Australian dollar with a loss of approximately 35 per cent versus the Japanese yen at year end.
The British pound was another laggard over the year, trading at all-time lows versus the euro as the currencies flirted at parity level. Should the prospects for global economies improve, dismal performers like the sterling would result among the main beneficiaries, while the dollar would be expected to lose further ground as risk avoidance falters. Possible dollar depreciation may be accompanied by some euro appreciation if the euro-area does not fall into a protracted period of recession or the ECB keeps on dragging its feet on lowering interest rates.
The euro may suffer further selling pressure versus the sterling given the slower pace with which the ECB is lowering rates when compared to its British counterpart. Low commodity prices and waning global demand should cap any upside potential for emerging market currencies.
Commodities - suffering from waning global demand
After a very strong first half in 2008 with soaring commodity prices at or near all-time high, prices had to succumb to global economic weakness. After sky rocketing to an all-time high of $147.27 per barrel in July, the price of oil plummeted to $35 per barrel late in December. Short term upside potential should be capped by lower global demand; nonetheless analysts' projections from a medium-to long-term perspective are still well above current market prices. On the other hand, gold lived up to expectations as it delivered a stable performance over the year. In absolute terms the price registered no significant move but in relative terms it outperformed most asset classes. In the short term prices are expected to move sideways but the possibility of dollar depreciation and the resurface of inflation in the medium term could heave the precious metal to higher levels.
The outlook for base metals is expected to be re-tested to the downside in the coming year given the sector's strong correlation to global GDP.
The agricultural sector was not immune to the market turmoil even though the sector is not highly leveraged and analysts' are still relatively optimistic on a medium-to long-term perspective.
Any upward movements are likely to be supply side driven (supply shortages and disruptions) rather than demand.
• The information and opinions were prepared by the Research & Analysis Unit, Bank of Valletta plc (BOV). The information herein is believed to be reliable and has been obtained from public sources believed to be reliable. BOV makes no representation as to the accuracy or completeness of such information. BOV has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. BOV shall not be liable for any decision made or taken in reliance on such information. This report is provided for informational purposes only.
It is recommended that if an interested person requires investment advice or wishes to discuss the suitability of any investment decision, s/he should seek financial, legal or tax advice from his/her professional advisers as appropriate. Income from an investment may fluctuate and the price or value of financial instrument, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results.
• The author is an investment analyst at Bank of Valletta plc.
kevin.polidano@bov.com