The financial system as we grew to know it over the past decade is likely to be dead and buried. High long-term global growth rates coupled with low volatility will be likely replaced by lower global growth rates and higher volatility. This will be the price we have to pay for living well beyond our means! The much awaited recovery will be slower than all its predecessors, as the credit multiplier will not provide the usual up-thrust, and the deleveraging (reducing debt) process lingers on.
The trajectory to financial Eden will be tested severely along the way before it gets a sustainable hallmark. It will be very important to assess the state of the economy once all the government liquidity injected into the economy dries up, questions will then be asked once again on the willingness of the consumer to start spending as he takes the baton from the government to heave the economy to greener pastures.
The global recession has forced consumers and businesses across the globe to cut on their spending, leading to excess economic capacity. Low levels of capacity utilisation should keep inflation relatively subdued in the near term, but the mounting fiscal deficits that are currently being accumulated pose a significant upside risk to inflation in the longer term.
Although there are legitimate reasons to be concerned about inflation, deflation still remains the immediate threat. With unemployment likely to rise above 10 per cent in both the US and within the euro area by the end of this year and excess capacity at multi-year highs, inflation concerns may be moved on the back burner for the time being, nonetheless, however, a protracted period of deflation maybe as equally devastating.
The near collapse of the financial system has heightened risk aversion across the globe. This means that igniting economic growth through debt will be an arduous if not an impossible task. Restricting access to debt will force countries to better align their savings and investments. What happened over the past 15 months was described by many world leaders as "unprecedented".
The magnitude of the stimulus injected into the global economy was also unparalleled. Removing this inundation of liquidity without upsetting economic activity will be as big of a challenge as awakening a patient from a 15-month coma. Nevertheless, the "patient" is already showing some positive signs of stabilisation.
Over the past few months central banks and other international organisations have signalled signs of optimism, even though economic data is still languishing in negative territory. The pace of decline has abated and in some areas like the manufacturing sectors we are actually approaching expansionary levels. GDP forecasts for both 2009 and next year have been revised higher with most economies expected to return to positive growth in the first half of 2010.
Economic recoveries should be more pronounced in those countries that have taken rapid and significant policy action, mainly the US, China, Brazil and the UK. According to market consensus, emerging markets should top the world's growth rates as the developed market struggles to catch up. Unfortunately, the eurozone is expected to be among the laggards to come out of the recession. The European Central Bank's hesitance to lower interest rates and initiate liquidity injection into the market may prove very costly.
Financial markets tend to anticipate the economic cycle, as market participants base their investment decisions on expected earnings and cash flows. If this theory holds, we should be on our way to recovery as both equity and bond markets have posted significant comebacks from the abyss. But how sustainable will this resurgence be?
Bonds - alive and kicking
The bond market proved many people wrong during the first half of this year, as fixed income investments brushed off their tag of boring investment vehicles. Non-investment grade bonds were among the best performers in all asset classes, outperforming developed equity markets by some significant margin. Corporate bonds within the investment grade tier had also their share of gains as they registered high single digit returns. Even after this positive start to the year, the bond market still holds value to the astute investor.
As customary, the main determinants that will shape the bond market performance will be credit and interest rate risk. Bond yield spreads for both investment and non-investment grade bonds remain well above long-term averages, signalling the possibility for further spread tightening. Fixed income should benefit from the deleveraging process as companies pay up their debts, retain excess capital and refrain from capital expenditure programmes. While this does not look very dazzling to equity investors, it surely portrays a rosier picture for all existing and prospective bondholders, as capital ratios improve.
Central bankers will once again play a vital role in shaping the bond market performance. Interest rates are expected to remain on hold at least for this year across the US, UK and the eurozone. Policymakers have openly stated that it is in everyone's interest that interest rates remain relatively low for an extended period of time, until the global economy starts growing again. An environment of low interest rates is an ideal setting for a strong bond market performance.
Although the outlook for the bond market looks upbeat, investors should still exercise caution when selecting specific fixed income investments. Before this financial turmoil, few were the investors that paid any attention to bond ranking and classification. Nowadays, this has severely changed. Bond investors are now distinguishing between bonds that are senior and secured in nature to the riskier subordinated bonds, which in case of bankruptcy will only rank prior to the equity holders.
A large number of subordinated debt holders have already experienced some "shave-offs" or exchange offers, where issuers offered to buy back their own debt at a discount. Such offers have been very pronounced with financial companies, especially those that have benefited from government aid. The possibility of further purchase or exchange offers, have capped any significant upside potential for subordinated bond issues. Risk-averse investors should therefore continue to opt for higher ranking bonds, within the investment grade tier as default rates in the high yield sector of the market are expected to continue rising.
According to Moody's credit rating agency, global default rates in the non- investment grade area are expected to peak at 12.8 per cent in the fourth quarter of this year. This figure has been lowered from a high of 13.5 per cent. Nevertheless, a 12.8 per cent figure signals that one in every eight high yield bonds is expected to default!
Equities - building up small positions
Over the past three months equity markets have staged a significant comeback as investors' risk appetite came back to life. Although equities did register a marked improvement, we are still nowhere near the financial nirvana of 2006/2007. Investor's wealth has been severely tarnished and it will take time before confidence in equity markets is fully restored. Huge piles of cash are still being held on the sidelines, as market participants contemplate possible investments. Idle cash balances are considered to be a bullish sign for a contrarian investor, as the prospective inflow of cash back into the market would lead equities higher.
Most investors are asking themselves, whether the current market rally is really sustainable and if it is, where should they place their investments. The usual market valuation methods are still somewhat unreliable as a number of companies are still reporting losses. Earnings visibility is still blurred with a number of potential setbacks for equity markets. On the back of such an uncertain background, equity investors should lengthen their investment horizon and avoid increasing their expectations for short-term speculative trades.
Overall, the long-term outlook for equities should hold upside potential, but the course of such a trajectory may be dented by volatility and earnings' disappointment. The main drag on earnings prospects will be plummeting budget deficits and hence higher taxes, increased regulation thereby increasing company's costs, and lower levels of leverage and forced balance sheet repair, therefore, slower growth rates.
On the whole, one may consider to cautiously start opening up some small equity positions. Investors should position themselves in those sectors that are associated with the early stages of an economic cycle, mainly, transportation, technology and financials. A relatively underweight position should be held in companies that require a high degree of capital expenditure, like real estate and metals and mining stocks. With regards to geographic allocation, emerging markets will once again provide the steam to the global growth's engine with Brazil and China featuring among the most attractive developing economies. Within the developed market, US equities are looking in a better position thanks to the State's proactive approach.
Focus should be given to those US companies with exposures to the emerging markets as the US consumer is expected to keep on struggling to get his debt levels lower. For the less adventurous investor, the UK equity market still holds a very good dividend yield of 4.50 per cent on the FTSE 100, above the 10-year gilt of 3.97 per cent, usually considered as a buying signal for equities. Finally, the European market is expected to trail other foreign equity indices, with Eastern European markets stealing most of the negative headlines.
An alternative investment vehicle for those investors who would like some exposure to the equity market but at the same time limit their downside risk, are convertible bonds. The coupon payment and credit spread tightening should act as a floor for the hybrid's pricing while the possibility of a continued positive trend in equity markets would benefit investors through increased upside potential.
Currencies - questioning the world's reserve currency
The US dollar had to bear the brunt of the recent recovery in financial markets and questions have been asked about the greenback's status as the world's reserve currency. Some significant concern was expressed by a number of emerging markets holding substantial amounts of dollar reserves, as they see the value of their accumulated savings shrivel. Since the start of the market rally back in early March, the US dollar Index, which measures the value of the US dollar relative to a basket of foreign major currencies, has shed over 12 per cent as the appeal of the dollar's safe haven status diminished. But who will indeed dethrone the mighty US dollar? Probably no one single candidate exists but many aspiring contenders like emerging market currencies, commodities and the euro may benefit from the currency's depreciation.
According to Bloomberg data, as at the time of writing, the average forecast for the $/€ (dollar per euro) exchange rate stood at €1.39 for the second half of 2009 and €1.40 for 2010 thereby signalling no profound divergence, but if we had to delve deeper into the figure we would come across some remarkable insights. The variance between the lowest and highest market forecasts indicates the lack of direction in the foreign exchange markets. The lowest estimate for the euro for 2010 stands at €1.10, while the highest prediction is currently fixed at €1.56, an astonishing 42 per cent gap. On the back of such a variance, investors should exercise a higher degree of caution when taking significant foreign exchange position.
However, if one had to take a stance on the direction of the US dollar it would probably point further south in the longer term. The fact that the US government opted for aggressive counter measures in terms of both monetary and fiscal policy is likely to result in the US economy experiencing the first signs of inflation amongst developed economies; this would eventually weigh negatively on the dollar. Additionally the mounting US deficit is a gargantuan problem always bubbling on the back burner.
Emerging market currencies like the Brazilian real and the Chinese Yuan look very well positioned for further gains should the global recovery continues. On the one hand, currencies closer to home like the British pound and the euro may also test higher levels. The sterling should continue recovering from last year's hammering, although any significant appreciation may be capped through the reversal of the government fiscal and monetary stimulus. Meanwhile, gains in the European single currency may come at the expense of greenback's depreciation rather than the euro's own merit, making any possible uptrend less reliable.
Commodities - bland in the short term but attractive from a long-term perspective
Commodities in general have benefited from a combination of macro forces, including rising equity markets, weakening US dollar and a resurgent flow of funds into commodities. Even after the recent positive run, demand and supply dynamics for commodities remains somewhat weak. Inventories are still on the high side and big market players are still watching from the sidelines.
Most of the upsurge registered over the past few months was the result of an increase in demand for commodity exposure through Exchange Traded Funds that have now become a determining factor in the prices of some commodities. Commodity investing is usually associated with a maturing economic cycle, now, there are still a good number of sceptics stating that we have not reached the trough of the economic cycles yet, let alone maturity stage.
Everything looks set for yet another volatile five months for commodity prices. The price of oil has been trading within the range of $50 to $74 per barrel since the start of March. The average price forecast for the price of oil for next year is $71.75 per barrel based on a number of foreign contributors on Bloomberg. Nonetheless, the long term outlook for the price of oil still points to higher prices and will probably test again the $100 per barrel levels, as the global economy remerges from this downturn.
Meanwhile, the price of gold has continued to flirt with the $1,000 level an ounce. Further dollar weakness and upped demand from fund providers could see the precious metal seriously testing the four digit level. The median analyst forecast for the second half of this year is around $952 per ounce, while the price estimate for next year stands at $964 per ounce. Gold investing would be ideal for those investors who are heavily exposed to the US dollar and would like to hedge some of the dollar's further depreciation.
Among the broader commodity index, the soft commodity sector still holds a number of positive attributes that should support the sector in the longer term. Factors like soaring population growth, urbanisation in emerging markets, scarcity of land and water, declining global food stocks and climate change should provide a strong impetus to the agricultural sector.
The author is an investment analyst with Bank of Valletta's Research and Analysis Unit.
The information and opinions were prepared by the Research and Analysis Unit, Bank of Valletta plc 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. Opinions, estimates and projections in this report constitute the current judgment of the author as of the date of this report. They do not necessarily reflect the opinions of BoV and are subject to change without notice.
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kevin.polidano@bov.com