The first two quarters of 2009 couldn’t have been more different on the financial markets. While investors exhibited strong risk aversion in the first quarter, the second quarter saw the very same investors return to equities and high yield bonds. The stock markets reflected this renewed interest, recording their best quarterly performance in many years: after shedding 24% between 1 January and 9 March, the MSCI World went on to gain 47% between 9 March and 2 June. Since then, the index has remained stagnant.
In terms of investment strategy, the asset classes an investor should have owned differed fundamentally during these periods. For the first two months of the year, the optimal strategy would have been to give priority to defensive over cyclical companies in equity portfolios (or to get out of equities completely), prefer government bonds over high yield bonds in fixed income portfolios, and the dollar over the euro in terms of currencies. Starting in mid-March, an investor would have been well-advised to return to equities (in particular cyclical and commodities-related stocks), avoid government bonds and buy euros.
Investors’ readiness to move back into risky assets again was encouraged by what the markets are calling “green shoots” of recovery. Indeed, in the past few months many analysts seem to have made a pastime of hunting down indicators to confirm these green shoots.
An investor should always have an idea of the economic scenario priced into stocks and bonds. In March, stock prices were factoring in a scenario of continued deterioration in the economic situation, today they are factoring in a sharp recovery in company profits. Consequently, at the start of March, it was enough for news to be just that little bit less bad than expected for prices to rise. However, it will take more than that for a sustainable rise in stock prices to continue in the second half of the year and there will need to be more tangible signs of recovery.
I have already explained why I believe that the conditions required for a sustainable economic recovery in the industrialised countries are not in place. The two players whose ever-increasing recourse to debt had inflated growth in recent years, namely the US consumer and the banking sector, have begun a process of deleveraging that will last many years. Currently, there is nothing to replace these players as the engine of world economic growth. Recent data from China is encouraging, but Asia's transition from export-led to internal demand-driven growth will take some time.
The ‘green shoots’ that analysts seem to be able to detect are mostly indicators showing that the pace of economic deceleration is slowing down. The slump in activity following the collapse of Lehman Brothers investment bank was dramatic as illustrated by first quarter 2008 and first quarter 2009 data, and it was quite simply unthinkable that the world economy could continue to deteriorate at this pace. Data apparently pointing to imminent economic recovery should be interpreted in this light. It could be that economic activity has (temporarily) bottomed out, but there is nothing in the latest economic data to suggest that we are moving towards a sustainable recovery (it is important to emphasise the “sustainable”). It is possible that the rebuilding of inventories predicted by many analysts could temporarily boost growth. Unless final demand picks up, the phenomenon will be short-lived, however.
In my opinion, expectations of a strong durable recovery increasingly priced in by the markets will be disappointed. If this were the case, the ideal portfolio for the second half of the year, would resemble that of the first quarter. It would have a defensive orientation in terms of the overall asset allocation (lowering the equity weighting) as well as within each asset class (defensive stocks over cyclical stocks, government bonds over high yield bonds, dollar over euro). The main threat of such a defensive strategy is that risky assets will continue to benefit from a liquidity effect. Investing in equities for fears of underperforming an index, or because the return on money-market investments is weak, is not a good idea when fundamentals are weak, however.
