Economic & Financial Market Background
August was a hugely volatile month for the financial markets as investor risk aversion reached extreme levels. Measures of volatility soared for both equities and bonds as prices slumped for the former and soared for the latter. Indeed, short-term historic volatility for the S&P 500 and U.S. 10-year Treasuries surged to levels last experienced in the first quarter of 2009. The essence of the month was not just a decision by investors to lower equity exposure but to actively increase positions in only the “safest” of assets. So, while the S&P 500 closed the month down 5% (although with massive volatility intra-month, up 12% trough to peak), 10-year+ U.S. Treasuries returned a massive 8.4%, a gain only beaten in November and December 2008 at the peak of the “financial crash”. This was also evident in the buying of only the safest of currencies with the Swiss franc so aggressively bid (9% in the early days of the month) that the authorities set a lower minimum exchange rate versus the euro that they promised to defend.
The scale of the move in “safe haven” government bonds resulted in ten year yields in the U.S., U.K. and EU reaching multi-decade or all-time lows with both U.S. and German yields dropping below 2.0% and U.K. gilts to just below 2.25% (and this level for a country with headline inflation running at 4.4% and a budget deficit for next year expected to be amongst the highest in the world!?)
The catalysts for such investor anxiety were both extremely positive for high quality government bonds. Firstly, even after the prior month’s savage cuts to most of the advanced countries GDP forecasts, the process was repeated during August. Overall, most estimates for global growth still hold in a 3.5% to 4.0% range for both this year and next, but this is principally due to expectations of continuing strong growth in the emerging/developing economies which now account for around 50% of world GDP (PPP basis) and contribute a far greater proportion to annual growth.
The speed of the decline in GDP forecast in the advanced economics is startling and has resulted in expectations of above trend growth swiftly falling to a sub par advance. Such a decline in GDP forecasts has added to the vulnerability of the advanced economies slipping into recession and indeed, U.S. recession probability is now generally thought of as around 35%. The table shows current GDP forecasts for the main economies for this year and next and compares them with those in the July GIS document of just two months ago (i.e. the figures in brackets).
Despite the shock to corporate and consumer confidence precipitated by the debt ceiling debacle, the S&P downgrade of U.S. sovereign debt, the eurozone sovereign debt crisis and extreme financial market turmoil, the U.S. economy has not collapsed. Indeed, more recent data released have somewhat calmed fears of an abrupt slide into recession as in 2008, and actually indicates that in the early part of 2011's third quarter at least, GDP growth is running at about a 2.0% pace compared to many estimates for the quarter of around 1.0%.
As noted above, both the U.K. and EU also experienced substantial downgrades to GDP growth forecasts. Recession is a reality for the poor beleaguered U.K. consumer while negative shocks in Europe are coming from all directions. Recent PMIs (purchasing managers' indices) are hardly comforting and warn of a difficult second half of the year.
The second main catalyst for such high financial market volatility was a further worsening of the eurozone sovereign debt crisis. Measures undertaken by EU governments and the ECB to try to resolve the issue have been viewed by many investors as not only insufficient but also lacking the political will to avoid a more calamitous outcome for the EU and particularly its financial system. George Soros recently noted “This crisis has the potential to be a lot worse than Lehman Brothers” and is the reason why many bank stocks have fallen so heavily in recent weeks, especially those with large exposure to Greek and Italian sovereign debt.
The financial market turmoil and growing fears of recession have caused a radical change in expectations for further bouts of monetary stimulus by central banks. QE2 in the U.K., QE3 in the U.S. and possibly even rate cuts in Europe later in the year are now beginning to be priced into markets. Together with another U.S. fiscal boost (a further extension to payroll tax cuts) this may begin to salve investor anxiety which, it should be noted, has resulted in equity valuations at levels that in the past have provided strong forward returns. As Citigroup recently commented “The world probably needs to break to not honour these historical return relationships”.
Asset Allocation Views
Equities
Expectations of a second half recovery in the global economy led by a U.S. private sector spending rebound have been dealt a terminal blow. GDP growth forecasts in most advanced countries have suffered savage cuts as a combination of a serious escalation in the eurozone sovereign debt crisis and substantial falls in business and consumer confidence has resulted in severe financial turmoil threatening a vicious downward spiral. Even after a 12% or so fall in equity markets risks remain elevated and further high levels of volatility are still probable. In such a fragile environment with substantial downside still a possibility a tactical underweight was considered but, given the speed of market swings and the prospect of further monetary and fiscal support, a neutral position was retained. No early resolution to eurozone debt issues is likely, however, and remains a major concern. The medium term outlook for the advanced economies and corporate earnings is now far more opaque with governments being forced to accelerate deleveraging at a time of far greater economic and financial greater uncertainty, resulting in the economic growth trajectory being lower for some time to come. A good long term option, with cash offering a zero nominal return and government bonds a negative real return, is to invest in defensive, high quality companies with strong cash flows, high yields, growing dividends and with exposure to growth markets.
Bonds
With main market government bond yields at such low levels, it makes little sense to increase weightings unless a recession is expected. Even then yields are already lower than they were when the main economies were crashing at a 5% year-on-year pace. On fundamentals the huge bond rally appears overdone, especially with the scale of government debt and deficits but, given current growth uncertainties, prospective stimulus via bond purchases and no sign of respite in the eurozone debt crisis, yields could stay at lower levels for a while yet. Quality corporates look a better bet, as do emerging market bonds.
Property
After such a strong yield impact-led recovery in capital values the pace of advance in the U.K. property market has slowed to a crawl. The weight of money chasing high quality properties generated a near boom and prime yields seem fairly fully priced. With banks now becoming keener to supply the market with portfolios of properties from their involuntarily built stockpiles and lower levels of investor interest at current prime yield levels, this should inhibit further capital value gains and indeed, they could decline over the second half of the year. Selectivity is important and Central London, especially offices and retail, remain favoured. With yields now in excess of 4% above ten-year gilts for even some prime properties the sector should outperform both cash and government bonds from current levels.
Commodities
Predicting commodity returns is normally difficult enough given the very broad spread, high volatility and problems associated with rolling over futures contracts on returns. It has become even harder as a result of the uncertainty created by EU sovereign debt issues and a growing risk of U.S. recession. Commodities such as crude oil and industrial metals have fallen sharply during the recent sell-off but nowhere near as steeply as many other risk assets. As long as the Chinese economy avoids a hard landing and the U.S. economy experiences nothing worse than a slow recovery, the pace of world economic growth should be sufficient to ensure that the prices of supply constrained industrial materials, such as oil and copper, will not collapse and indeed could return to cyclical highs next year. Gold recently reached a new closing peak of $1,898/oz and will remain favoured by many investors worried that a far worse fate awaits the global economy. Scarce supply and strong demand will keep prices rising until sentiment turns and real interest rates rise. Drought conditions in the U.S. are resulting in disappointing crop yields and grain prices look set to trend higher.
Currencies
Currencies remain as volatile and as difficult to predict as ever. Near term trends will depend on the authorities’ response to current financial turmoil but the Swiss franc and yen are unlikely to strengthen too much further given counteracting flows from the respective central banks. In recent weeks the euro has lost all its interest rate differential support and, with the eurozone crisis intensifying, even the other “uglies”--sterling and the dollar--may well outperform the euro despite the prospect of QE2 and QE3 respectively. Asian emerging market currencies remain amongst the most favoured longer term given many are undervalued and most have none of the structural issues afflicting most Western economies.
Andy Brunner is investment strategist with OBSR, a Morningstar company.
