The markets have now reached a critical stage. To justify a continuation of this rally, or even current levels, it will no longer be enough for the news to be less bad than expected. New news will have to confirm the expectations of an economic upturn in the second half of 2009. And this upturn will have to be significant given that the consensus of analysts is anticipating an increase in company profits (excluding the financial sector) of 45% over the next two years. The 600 to 1,000 range for the Standard&Poor's 500 index established at the start of the year (22 January article) was a reflection of this reality. When the index is at the lower end of this range, investors are pessimistic and all it takes is some news that is a little less bad to send prices back up. When the index is at the upper end of the range, investors have become more optimistic and the market becomes vulnerable to disappointing news. Obviously too, at the lower end of the range, valuations are significantly more attractive.
So what is the economic situation looking like now and can we really expect relatively strong economic growth in 2010? First of all, it's worth noting that the signs of a recovery that investors seem to be detecting are nothing more than a stabilisation of certain indicators which in some cases had previously fallen to their lowest level in several decades. Yet there's nothing particularly surprising about this stabilisation. The decline in economic activity after the collapse of Lehman was so extreme that there was bound to be a slowdown in the pace of deceleration. The statistics at the origin of the market recovery therefore have to be seen in relative terms: economic activity is continuing to slow - it is just slowing less rapidly.
Whether economic activity is close to bottoming out or not is one thing. But to me, the fact that the conditions for a sustainable recovery are not present seems more important. Many investors seem to be underestimating the gravity of the current crisis, especially the dangerous relationship between the financial crisis and the economic situation. This relationship could be sketched out in a rather simplistic way like this: the financial crisis has reduced the banks' capacity to grant credit and is thus aggravating the economic recession; and the economic recession is reducing the capacity of economic agents to honour their commitments and is thus weighing on the quality of the banks' balance sheets. A recent survey by the International Monetary Fund showed that economic recessions accompanied by a banking crisis lasted on average twice as long.
In most recessions in the past, there were some quarters in which growth was positive. So it is not impossible that growth will return to positive for a few quarters. But we are not in a classic recession and there are currently cyclical and structural brakes dragging on a sustainable recovery.
First the cyclical brakes. The two main components of US Gross Domestic Product are personal consumption (representing ~70% of GDP) and corporate investment. Personal consumption is principally financed by consumer income. For the first time since the depression of the 1930s, incomes are now falling in nominal terms. The unemployment rate has practically doubled in the United States, going from 4.4% in October 2006 to 8.9% in April 2009. American companies are continuing to reduce their wage bills aggressively. In the short term, this helps their profits (if the results posted by American companies so far for the first quarter are less bad than expected, it's only because of their cost reductions - their revenues have in contrast remained below expectations). In the longer term, this saps consumer spending power and therefore corporate sales. The unemployment rate could therefore soon exceed 10%, a situation that is hardly conducive to increasing wages. In March, the capacity utilisation rate fell to 69.3%, its lowest level ever recorded (statistics have been produced since 1967). The level of excess capacity created by the current recession is unprecedented in recent history. This situation does not augur well for a strong increase in corporate investment over the next two years.
Next the structural brakes. We are currently seeing a process of deleveraging in two sectors that are very important for the economy: banks and households (especially in the US). Just as the process of increasing debt had artificially boosted growth, the process of deleveraging will hold it back. The banks will steadily reduce their leverage from 30 ($30 of liabilities for $1 of capital) to nearer 10. This will by definition have repercussions on credit availability. (While we are on this subject, it is worth noting that the credit crunch is not solely due to the fact that the banks don't want to, or can't, lend but also due to the fact that the demand for credit has fallen off.) To the cyclical problems of US consumers described above should be added the structural problems of high debt and a lack of savings. In the last 25 years, the level of US consumer debt has more than doubled, going from $0.44 for $1 of GDP in 1982 to $0.98 in 2007. Until the end of the 1990s, the increase in debt could be justified by the improvement in consumer fundamentals (lower inflation and interest rates, increase in available income in real terms, fall in unemployment, and increase in the value of the financial assets they held). But this has not been the case since 2000. Savings had to nose-dive to continue to prop up personal spending in an environment of slow employment growth, stagnating incomes and disappointing stock market performance. The fact that households managed to continue increasing their debt despite the erosion of their fundamentals was thanks to many banks' irresponsible credit policy. Unless one thinks that the process of US household debt reduction will come to an end sometime soon, it's hard to be very optimistic about the prospects for growth in the US economy.
An environment marked by a high level of debt, a crisis in the banking sector, and a fall in consumer income is by definition dangerous and conducive to strong deflationary trends. In this environment, the monetary policy of the central banks has lost much of its effectiveness. In the majority of industrialised countries, short-term interest rates are now close to zero. To continue to stimulate economic activity, the central banks are increasingly resorting to quantitative easing by buying up government bonds or mortgage- or consumer credit-backed loans in order to lower interest rates. Paradoxically, however, investors' newfound optimism could well endanger their efforts since the expectations of a recovery in the second half of the year have already prompted a rise in long-term interest rates. In the United States, the 10-year government bond yield has gone up from 2.05% at the end of 2008 to 3.34% today.
In short, the economic situation continues to be worrying and stock markets would have to be considerably cheaper to be able to say that "the bad news is priced in". Operating profits for companies in the Standard&Poor's 500 will be around $40-45 per share in 2009. At the S&P's current level, the price/earnings ratio is around 21. This is not cheap even though it could obviously be argued that profits for 2009 will be abnormally low due to the recession.
What then are currently the risks related to a prudent strategy with regard to equities and risk assets in general? First,that my pessimism about the capacity of the global economy to rebound strongly and sustainably is generally exaggerated. Then there is the possibility that this pessimism is not exaggerated over the medium and long term but is exaggerated over the short term. In other words, economic activity could see a significant upturn for a few quarters, only to fall back thereafter. In that scenario, it would be premature to aggressively reduce equity exposure at the moment. And finally, there is the risk that the stock markets will continue to benefit from significant liquidity inflows from, on the one hand, investors who are dissatisfied with the return offered by money market investments and, on the other hand, by a catch-up phenomenon. Many fund managers have thus missed out on the rebound and are feeling increasingly obliged to get back into equities to avoid continuing to underperform their benchmark index. This liquidity risk is very real, especially since there doesn't seem to be an immediate catalyst to bring down analysts' medium-term earnings forecasts. Stock prices could therefore continue to rise for a while until the fundamentals once again regain the upper hand.
From the above, we should not include that equities do not have their place in a portfolio. Our investment strategy could be described as "structurally prudent, tactically opportunist". This opportunism led us to take advantage of the fall in stock prices in the second half of February/first half of March to increase equity weightings before reducing them again in recent weeks (1). We continue to favour regions, sectors and companies that have the means and resources to come out of the crisis with greater strength.
(1) In the second half of May there will be a new feature on this blog called "Managing a Fund". This will show how our analysis is incorporated in a practical way into our portfolio management, using the example of one of our funds, BL- Global Flexible.
