It is very hard to know where to start. The last month has been a chaotic mix of extreme market volatility, contradictory but generally poor economic data, baffling politics and bizarre actions from governments around the world, says Thomas Becket, Chief Investment Officer of PSigma Investment Management…
It has all made for a horribly potent cocktail that created a miserable month for global asset prices and has impacted badly upon investor and consumer confidence around the world. At times there were strong echoes of the misery that we suffered in 2008, as intraday market volatility spiked and indices and individual share prices fluctuated by amounts that had rarely been seen before. Making fundamental investment decisions in such conditions becomes almost impossible, but as long term investors it is vital that we try to see through the market and economic squall and plot an asset allocation course that will allow our clients the opportunity to benefit from market turbulence.
Therefore in our latest newsletter we will focus upon our current asset allocations and how we believe the global economy will perform in the next few quarters.
However, first we shall try to explain what has happened to create the mad scenes that have so far ruined any plans of a quiet and peaceful summer. There are two main contributory factors to the recent market falls; a general deterioration in global economic output and a complete collapse in faith of politicians.
The former is easiest to explain. The fragile recovery that commenced in 2009 with the turning of the business cycle and an unprecedented stimulus from central banks and governments has started to fade and fears over a “double dip” recession have resurfaced. We would argue that if we were heading back in to a recession then it is not a “double-dip”, but rather the business cycle starting to turn lower, following a restocking of global inventory levels from a low base in 2009. This would be reminiscent of the business cycle pattern of the 1970s or post 1989 Japan, when cycles were far shorter and aggressive (in both directions). Recent economic data from the Eurozone and the US has shown that the paltry levels of economic growth we are experiencing are already flirting with a shallow recession. With jobs growth now virtually non-existent and the manufacturing sector almost contracting, we have to question whether low growth, quickly becomes no growth. Sadly we think that this is now a decent probability.
It is not our central case, but certainly risks have risen that we may soon be re-entering another recession.
In order to break free from the grip of recession we badly need a boost to confidence across the world. Here is where the major underlying problem exists.
Because of the squabbling of politicians in both the US and Europe, there has been no clear guidance from the political “top table”, at a time when consumers, investors and corporate managements have needed to see a steady hand of the tiller of the global economy. We now have finally seen a resolution to the debt ceiling debacle in the US, although the cracks that appeared in the political landscape are too wide to bridge easily. The recriminations and rebukes are still being hurled by both the Democrats and the Republicans, with fiery debates raging over job creation, stimulus and further monetary easing. With the 2012 election looming depressingly on the horizon the partisan pantomime is only going to get more ridiculous. The temptation to vote for “None of the Above” as in the cult film Brewster’s Millions, must be very high.
Amazingly, the Europeans are still managing to out-do their American peers when it comes to illogical political actions. Having hastily put together another “bail-out” (or was it “bail-in”?) in July, the European leaders all de-camped to their holiday homes on the Mediterranean, satisfied with victory in the latest battle in the war over European debt. Their satisfaction was badly misplaced. Almost as soon as the Piz Buin was broken out, peripheral bond yields started to rise again and prices fell, as investors quickly saw through the shambolic solution to the European debt crisis. The politicians declined to break their barely-earned vacances and tried to conduct a rescue effort from their sun-loungers. It didn’t work.
We are still yet to see any decisive resolution in Europe, which remains the greatest market risk, whilst now we have seen the tentative political union dissolve in to factions and fighting. All the while that the politicians play the fiddle, the fires in the periphery continue to burn and now the politicians also have to contend with an economy teetering on the edge of recession. For now the European Central Bank is propping up the bond markets by buying huge swathes of the problem countries bonds. Eventually, someone is going to have to come up with a proper resolution, most likely to be debt default and debt forgiveness, but until we get there it will be extremely volatile in Europe, in many ways.
There has also been talk of further Quantitative Easing in the US, as the Federal Reserve desperately tries to stave off the recessionary threat. Despite their initially calming commitment in August to maintain interest rates at record low levels for the next two years, there has been an ever-growing clamour from worried investors for further action. This could well lead to a resumption of the bond buying bonanza of late 2010 and early 2011 that generated strong growth for global asset prices, particularly commodities, although success outside of financial markets was hard to detect. In fact, one could say that the whole programme did nothing but create a bigger mess to deal with further down the road and an inflationary impact that was felt across the world. That is not to say they won’t try it again, but we would be far more comforted to see the US government actually try initiatives that might reduce the huge levels of unemployment that
act as a deterrent to growth. Maybe President Obama’s forthcoming address will go some way to allaying concerns about structural unemployment in the world’s biggest economy. At least it can’t be as ineffective as the last series of stimuli announced in 2009. Or can it?
At least there are reassuring signs that the Emerging Market economies are still weathering the economic storm successfully and these countries find themselves much better equipped to deal with a slowing global economy. However, these economies still need decent growth so that they can keep their growing populations employed and satisfied. All across the world the potential for social unrest has risen, as evidenced in the UK over the last month.
The worst performing asset class over the last month has been equities, whilst commodities and corporate credit have also suffered. That is no great surprise following the resounding gains that investors enjoyed from March 2009 to the early days of this summer. What is a surprise, given that they were the source of the markets’ problems, are the astounding gains in government bond markets. Investors have been willing to ignore any inflation or default threat and accept tiny yields just to hold what they believe to be “safe haven” assets. We continue to find this course of strategy wrong for the medium term, although we acknowledge that our ability to protect capital further in recent weeks has been hampered by our strong belief in the unattractiveness of these assets for the long term. We continue to favour a mix of high quality global companies and short duration high yield bonds in our client portfolios. Despite the uncertain nature of the returns in the short term, we feel strongly that we will be able to generate healthy returns over the next few years.
On the bottom of the leader-board has been the shares and debt of banks, which have been sold off aggressively as question marks have once again been raised about the scale of the problems at European banks. European banks are being frozen out of the lending markets, in a similar fashion to 2008.
Whilst we can agree with the optimists that this problem remains relatively contained and has not yet spread to other sectors, we are extremely worried that the contagion threat might affect other geographies and industries. This is another material threat to the global economy and we repeat our wish from earlier in this newsletter for the Europeans to get their house in order. Whilst the global economy is certainly far from great, it is ok, but obviously it is definitely at threat from a lack of decisive action from Europe. If concerted and clear action is taken, we believe that the last few months of this year might be more than satisfactory for the economy and financial markets, particularly if evidence of a resurgence in corporate demand does come through, as we previously had expected before the political poison polluted the summer months.
News from the corporate sector actually remains strong, with mergers and acquisitions still taking place and corporate managements making promising noises about the future. However, any remaining confidence could easily dissipate within a matter of seconds, were a messy conclusion to occur in Europe. 2012 still looks very questionable and we remain open to a number of different scenarios that could impact upon asset prices. We believe that the chances are evenly split between recession, a bumpy and low economic grind upwards and a more healthy recovery. Worryingly much will depend on government policy in the months ahead.
Having spent much of the last year de-risking our investment strategies, in anticipation of a more uncertain economic environment, we have now started to re-evaluate opportunities that have been created by the recent market fluctuations. Good companies have been sold off along with the bad, so we have the opportunity to rebalance our portfolios. However, any changes to our investment strategy will not detract from our general philosophy of diversification, which we believe is more important now than ever given the unprecedented number of possible outcomes. It is hard enough trying to put confidence in your own investment decisions in such market conditions, but having to give confidence to undeserving politicians can be a step too far. This is particularly the case after the last few months.
