Is the recovery over?

By Noel O'Halloran , Thursday, 1st July 2010 | 0 comments

After a positive first quarter in 2010, the second quarter was a turbulent one.  The markets oscillated between “risk love” at the beginning of the quarter and “risk aversion” at the end of the quarter.  In April, strong equity markets and increased risk appetite were quickly pricing in a traditional “V” shaped economic recovery.  May, however, quickly became the opposite, as the markets rapidly moved 180 degrees to fear a relapse into a double dip global recession.  

I have written for some time that we must expect such volatility, until such time as investors finally recognise that the reality for the global economy and markets, over the next 5 years at least, is going to be a slow growth world as we pay back for the excesses of previous cycles. Such “new reality” means that for me, both April and May are incorrect extremes in markets and the fundamental reality lies somewhere in between.

 Returns for the quarter
%
World Equities (MSCI, €)
-3.3
European govt bonds (BAC/ML 5yr+, €)
+0.1
Eurozone Equities (MSCI, €)
-8.7
Euro vs. US Dollar
-9.5

 

  

The major event to shake confidence and markets in the second quarter was the Greek sovereign debt crisis, which subsequently broadened into a European sovereign debt crisis. A weak euro was the markets’ mechanism for highlighting the weaknesses of Europe. The ECB and governments responded with great resolve which helped underpin markets. However, markets were not completely comforted, and we are left with a strong debate as to whether the strong austerity measures being taken by governments will kill or cure the economic recovery in Europe. I believe that the correct steps are being taken and the result will be somewhat slower growth over the short term with a more positive medium term outlook.

 
Two other compounding concerns emerged during the quarter:  fears that the US economy was losing momentum and fears that the Chinese economy was about to slow sharply. Both these concerns surrounded reactions to more mixed economic data in the second quarter and especially when compared with more resilient and positive data during the first quarter.
 
We remain very confident that the Chinese leaders will achieve the necessary softer pace of growth in their economy that they have targeted by various fiscal and monetary policies over the last 6 months. We do not subscribe to a hard landing in the Chinese economy and therefore believe that far from killing the economy the authorities are actually ensuring they manage a prolonged economic cycle for China.
 
As for the US data, there is a difference between negative growth and a more mixed pace of growth which we have just experienced during the second quarter. For me, markets are impatient and investors are struggling to build into their expectations a world of more moderate and volatile growth, and not a double dip recession which I see as a low probability outcome. In my recent note to you titled “May Fire Drill”, I highlighted how quickly things can quickly go wrong again, and why strong macro leadership is paramount.

  

Whilst the quarter was associated with a decline in optimism, primarily as a response to these headlines, a number of positive events continued to unfold from my perspective:
·         Companies continued to deliver strong earnings ahead of expectations
·         Company balance sheets and cash flows are particularly strong, and leverage levels very low
·         Central banks and governments remain extremely alert and responsive. Emerging market economies continue to grow strongly
·         Inflation remains a non-event which allows interest rates to remain low for a long time
·         From a valuation perspective, recent market setbacks have restored value in many asset classes with the exception of government bonds. Current German bond yields of 2.50% are at a 200 year low!

·         Despite the quarter’s setback, most equity markets are still 50% or more above their lows of 2009

 

Our central scenario remains that we are just at the beginning of a global economic recovery and not the end, so no the recovery hasn’t ended! Over short term periods markets are driven by sentiment, both positive and negative, but over the medium term fundamentals matter, and our baseline scenario remains that the economic and market recovery remains on track and that this in itself will provide comfort to risk assets and reverse some of the risk aversion moves of the second quarter. If necessary central banks have the fire power to become extremely aggressive via quantitative easing should it be required

 

In managing portfolios, and particularly in such a volatile environment as we are in, discipline and patience are very much to the fore in our thinking. On a twelve to eighteen month time horizon, I continue to expect double digit returns from real assets such as equities and commodities. Over the summer months, it is most likely that markets will continue to struggle in a range bound manner, and should regain more positive momentum in the autumn and looking forward into 2011

 

I repeat our message that such a secular investment outlook requires a diversified portfolio of assets, country and sector exposures. Within portfolios I continue to favour emerging markets, high quality companies over poor quality and continue to emphasise dividend income as a very important component of total return.

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