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What's next for the global economy? Is the much anticipated recovery under way?
Scott Klimo, Bennelong SGI Portfolio Manager, shares his views on what we can expect during the next quarter.
Debate about global economic recovery is rife. Is recovery really under way and if so, what will it look like across the globe?
There's one camp that supports the theory of a "V"-shaped recovery - the belief that the harder the economy falls, the bigger the subsequent bounce.
Given recent market and individual stock movements, we're not in the "V"-shaped recovery camp. We favor the idea put forward by one of our consultant economists - the square root shaped recovery. While inventory re-stocking and the like in the US will lead to an economic rebound, we believe that the momentum will soon peter out and growth will flat line.
Where to for the US?
Overall, we have a cautious outlook for the US economy which stems from two factors: the over-indebted, increasingly unemployed consumer and the under-utilised industrial base. At the end of the first quarter we wrote:
With regard to unemployment, we note that the current level of 8.5% is perilously close to the consensus forecast of 8.9% unemployment in 2009. At March's rate of increase we will hit the consensus number this month. Meanwhile the median forecast of 9.3% in 2010 will certainly be exceeded in the current year.
The recently released 9.5% unemployment number indicates that consensus has been wildly optimistic on jobs and that a distressingly large number of economic and market commentators can't recall the early part of the decade when unemployment continued to rise for 18 months following the end of the 2001 recession. Unemployment has further to rise, dampening consumer activity.
Further contributing to a reluctant consumer is the increasing savings rate, declining incomes, the evaporation of the wealth effect and a far tighter credit environment. The Household Savings Ratio, which briefly touched negative territory in 2005, rebounded to 5.3% by the end of the first half. While a substantial increase, we are only now getting back to levels that marked historic lows in 1995. Since a negative savings rate can fairly be described as a severe under-shoot, it seems only rational to expect the rebound to overshoot in the opposite direction. We can easily envision double-digit savings rates.
Like the savings rate in 2005, capacity utilisation has hit post-WWII lows making the case for a rebound in business investment difficult to sustain. Indeed, major manufacturing industries such as automotive are aggressively shedding capacity.
Of course, it is important to remember that the relationship between asset markets and economic performance is, by no means, linear - except during times of severe dislocation. While we agree that economic statistics such as GDP growth will improve in the second half of the year, we believe that markets have likely already hit their peaks for the remainder of the year and the bias will be to the downside.
Chart 4: MSCI Global Index and Global GDP Growth
Of course, economies do provide direction to the market through earnings and a lackluster economic environment implies limp earnings. Earnings forecasts for the current year may not be too far off the mark as analysts probably overcompensated for weakness in the first quarter. Looking ahead to 2010, however, we are distinctly less sanguine than consensus when it comes to the profit recovery. It is this realisation that will drag markets down as the year progresses.
What about the rest of the world?
There are a number of adjustments being made in the US that are a required part of the anticipated profit recovery. Companies need to reduce costs (labor) to restore margins allowing them to raise wages, leading to stronger consumption, the need for increased investment and eventual hiring. Combined with the highly aggressive liquidity injections (a strategy that will have a short-term impact at the expense of long-term consequences), the US should emerge from the recession earlier than other major economies.
Among the laggards, we refer primarily to Japan and Europe. While Japan's financial sector may be in better health than that of the average developed country, it suffers from a hidebound political system, a reliance on overseas demand for its products and appalling demographics. Since the government has been implementing stimulus packages for nearly two decades, there is hardly a road or bridge that remains to be built.
In Europe's case, we believe that adjustments US companies are currently making will be imitated more slowly in the European Union due to union strength and political factors. In addition, consumers will be even more reticent to spend than consumers in the US. The financial crisis in Eastern Europe remains far from resolved meaning that currency collapse remains a real possibility and the European financial system has yet to come to terms with the state of its balance sheet. Even Fredrik Reinfeldt, Swedish Prime Minister and current holder of the rotating EU Presidency said:
We are warning that we are not through the financial crisis. There is still a financial crisis affecting the financial sector.
Of course, any ‘financial crisis affecting the financial sector' will also affect the rest of the economy. His words reflect the earlier estimate of the European Central Bank that banks in the 16-nation eurozone face potential write downs of $283 billion between now and the end of 2010, primarily due to loan losses rather than exposure to mortgaged-backed toxic assets.
Despite our negative view of Europe's economic prospects, we have identified a number of investment opportunities across a variety of sectors, including consumer non-durables, precious metals, banking, healthcare and services. Our current exposure to Europe is as high as it has been for some time.
Finally, Asia presents an interesting conundrum in that its financial system and personal balance sheets are in rude health compared to most of the rest of the world. Nonetheless, its economies remain overly reliant on overseas demand. Prior to the market downturn, this was especially true concerning Europe. Mercantilist economic policies prevented Asian currencies from strengthening versus the US dollar, which turned out to be a huge boon to Asian exports to Europe when the Euro soared against the greenback. When Euro strength evaporated and consumer demand tanked it was a double-whammy for Asian exports. Notwithstanding the rise of China as an economic powerhouse, Asia remains dependant on demand from the west. For that reason, we expect the realisation that economic activity will not return to buoyancy for some time to have as great an effect on Asian stock markets as on US and European markets. In other words, no de-coupling in the event of another market sell-off.
Perhaps none of the above sounds very encouraging but the beauty of a global fund is that there are always opportunities to discover good investments in some part of the world.
About Security Global Investors
US-based Security Global Investors (SGI) is a multi-disciplined asset management firm that seeks to deliver ‘Best-in-class' investment options for institutional investors and financial intermediaries. The firm manages approximately $20 billion in assets (as of January 31, 2009), and offers a broad spectrum of investment strategies that span five distinct disciplines - actively-managed specialty fixed-income, value, growth and global equity strategies, as well as quantitative investment management solutions. Founded in 1962, SGI has 314 employees (including 51 investment professionals) with specialised investment teams in Topeka, KS; Irvington, NY; San Francisco, CA; and Rockville, MD.
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