Monday, 13 July 2009

The long & winding road to recovery

Labelling the recovery with letters of the alphabet such as 'W' or 'V' is such a cliché. Song titles are far more effective. For example, the Vapors' Turning Japanese describes Japan-style deflation and Yazz's The Only Way Is Up describes a bullish 'V' shaped recovery. So, which song best describes the outlook for the world economy and markets… The Beatles' The Long & Winding Road?

Faced with considerable headwinds of reduced credit supply, corporate and consumer deleveraging, and falling house prices, GDP will remain below its long term average. The road to recovery is therefore going to be both long and winding. Indeed, the IMF noted last week that:

The global economy is beginning to pull out of a recession unprecedented in the post–World War II era, but stabilization is uneven and the recovery is expected to be sluggish. Economic growth during 2009-10 is now projected to be about ½ percentage points higher than forecast by the IMF in April, reaching 2.5 percent in 2010… the global recession is not over, and the recovery is still expected to be slow as financial institutions remain weak and credit intermediation impaired, support from public policies will gradually diminish, and households in countries that suffered asset price busts will rebuild savings.

So, although GDP growth is receiving a short term boost from fiscal and monetary stimulus and an inventory rebuilding cycle, the durability and strength of the recovery will ultimately depend on consumer spending. Since the US consumer accounts for c. 70% of GDP, US growth is likely to remain subdued until consumers save less and spend more. Furthermore, this is a global recession, which means that exports are unlikely to provide sufficient impetus to either GDP or consumption.

So, what does a prolonged period of below trend GDP mean for equity markets? Lower GDP growth implies lower earnings growth (see charts below). Therefore, P/E ratios will remain lower for longer since equity prices cannot move substantially higher unless supported by earnings growth.

Moreover, suffering from a debt hangover, management at over-leveraged companies are being distracted from growing earnings. Instead, they have to focus increasingly on reducing debt and balance sheet restructuring. Thus, companies who went into the credit crunch with robust balance sheets are likely to steal a march on their over-indebted peers. Anecdotal evidence of this includes Greene King's equity raising to buy pubs from distressed seller, Punch Taverns. In the housebuilder sector, Berkley Group learnt it's lesson from the last housing crash and went into this crash debt free, whereas Taylor Wimpey was in bad shape and returns on equity suffered…

However, even if equity prices remain stagnant for the next year, investors can still earn 5-7% p.a. in dividends, which is substantially higher than 12 month LIBOR at 1.5%. So, provided one invests in companies with sound balance sheets and dividend cover of over 2 times, the equity market is likely to be an attractive source of return.

Interest Rates
There is a limit to how high long bond yields can go while base rates are anchored at or near zero. With unemployment in the developed world converging on double figures and GDP remaining below trend, base rates will remain lower for longer. Thus, if longer yields rise too far, the carry becomes too attractive for them to rise further and institutions that can take advantage of low-cost funding from central banks will start buying, pushing yields lower.

However, this is a risky game and the stakes are high due to the many risks facing the government bond markets (QE overhang, record issuance and inflation to name but a few). Thus, in the UK at least, the yield curve has never been steeper, implying that investors are demanding a substantial risk premium over shorter yields to hold Gilts.

As discussed previously in Inflationistas have been smoking too much 'green shoots'! inflation is being kept at bay by a wide output gap. If GDP remains below its historical average then it will take longer than average to close the output gap, postponing inflation in the process.

In conclusion, the recovery has started in earnest, but it's going to be a long and winding road to recovery. However, provided one is positioned accordingly and with realistic return assumptions, there is no reason why the road shouldn't be a profitable one.