Market Review: February 2009 Commentary
As the world watched goggle-eyed at the inauguration of America’s 44th President, I wondered whether, in four years’ time, "Yes, we can!" will be have become "Yes, he did!".
Monday, February 16th 2009, 12:46PM
The Audacity Of Hope
Certainly there was an amazing amount of hope being expressed by the average US citizen (and probably hundreds of millions in other countries), that the refreshment of the new regime will be enough to turn the tide of the deep ocean of recession, credit crunch and wildly increasing unemployment.
In New Zealand, we have a double dose of refreshment, of course, with our own new Government as well, although I don’t quite see the same sort of hope being expressed here. Then again, New Zealanders are far too practical to jump on a bandwagon based predominantly on emotional expectation (except when supporting the Blues/Chiefs/Hurricanes/Warriors).
President Obama has certainly assembled a very good team of economic advisers. They have a great deal of experience, a fantastic understanding of market and economic forces and, seemingly, a commitment to aggressively solve the problems. The difficulty is that the problems seem to be getting much worse as time goes on. While the stimulus packages announced so far should be sufficient to stabilise the system and prevent major collapse, there is still not enough in them to supply much growth impetus. These stimuli have provided a lot of hope so far, but I fear what a possible reaction will be (by the markets) once there is a realisation that they simply won’t be enough. We probably saw a bit of this reality occurring in the sharemarkets in January, with the worst January ever for the US market and the worst inauguration day returns, despite all that expectant fervour in Washington and beyond.
Of course, all of the stimulus packages and bailouts need to be paid for somehow. The obvious way for this to be done is through the issuance of government debt. With governments around the world already guaranteeing lots of bank debt, having large government bond issues is only going to increase the supply of government-guaranteed bonds in the market. This is placing upward pressure on bond yields (we saw the US 10-year yield increase from 2.2% to 2.8% over the course of January), despite the increasingly gloomy economic data that is coming out.
The danger for the US economy (and the global economy by implication) is that instead of a “U”-shaped economic curve (that is, a sharp fall, with a brief bottoming out before a sharp rise again – although the current cycle would be a rather long and protracted “U”), is that it is, instead, a “L”-shaped situation – that is, a long, flat period without any recovery in sight. This was, of course, what happened in the 1930s Great Depression (the most extreme example), although I definitely do not think we are going to replicate that.
However, it was also the situation that occurred in Japan in the 1990s. This, I believe, is the most similar predicament to what the world is in at the moment. Hopefully, the US authorities do not make the same mistakes that were made in Japan, so we do not get a protracted “L”. To achieve this we need the US Treasury and US Fed to make appropriate fiscal and monetary policy moves as well as “quantitative easing” to steer the economy through this recession and ensure that it does not become a depression. The same needs to be followed by their counterparts in, especially, the UK, as well as the rest of Europe.
Both monetary and fiscal policy need to be carefully implemented in New Zealand as well. In terms of monetary policy, I believe Dr Bollard has done an excellent job in making the drastic cuts required. Remember, just seven months ago, the OCR was at a record high of 8.25%. Now it is at a record low of 3.5%, with 4% of that fall occurring in just over three months. That is the biggest drop in interest rates of any developed market and, temporarily, resulted in New Zealand having lower short-term rates than Australia.
But Dr Bollard still has, unlike Ben Bernanke, more OCR ammunition to play with. I expect to see the interest rates cut down to around 2% and then for them to stay at this level for at least the rest of the year and possibly well into next year. This will be required because the economic data coming out of New Zealand is likely to continue deteriorating. It hadn’t actually been that bad in 2008, but during January the adverse news started gathering pace. Unemployment is continuing to rise upwards and I expect it to be at least 7% by the end of this year. The dairy payout reduction clearly makes things weaker for the rural sector and the final payout may turn out to be even less than the $5.10 published recently.
Careful management of fiscal policy is also going to be a key (pun on the PM’s name fully intended). While we have tax cuts scheduled for April 1 this year, they are not particularly large. Compare that with what has already been distributed in Australia, who always seem to have far more fiscal action compared with our words and small promises. The New Zealand government may just have to take more action in fiscal policy.
We were the first country to enter into a recession and the hope is that we will be the first out. Monetary and fiscal policy will be an important part of achieving this, but we are still at the mercy of global trends.
And how will the markets react in all this? We are just about to start the new reporting season for New Zealand companies. The New Zealand equity market already has around 10.5% earnings reductions priced into it. Any further disappointments from this will result in stocks being sold off, but there is an allowance for the deteriorating environment to not have much of an impact on the sharemarket. Hopefully, the New Zealand sharemarket will be able to show the first signs of light at the end of this disappointing tunnel. At the least, there are some very attractive yielding New Zealand stocks available at the moment.
Global equities will, to my mind, struggle throughout the course of the year. They will continue to be extremely volatile and there are likely to be several brief short-term rallies (just as there were in Japan in the 90s). I have seen some of my peers predicting global equity rallies of around 20-30% from now until the end of the year. I also saw the results of a New Zealand survey that showed that over 50% of respondents expected global equities to rally more than 10% in 2009. That survey was conducted in late 2008 and I wonder how many respondents would have wanted to change their predictions after January’s poor global returns. I just cannot, though, see how such strong returns can be sustained in what is a terrible economic environment that is getting worse. In my mind, it is more hope than genuine expectation.
There are also several predictions published out there that global equity prices can rise by 30%-50% from here, without specifying a time period over which this increase will occur. These, of course, are not much use – global share prices will certainly rise by 50% from current depressed levels at some stage in the future, so such a prediction is going to come true at some indeterminate future date. Even a stopped clock is accurate twice a day.
In contrast, US Treasury bonds are clearly in a bubble that may have a little more to go before it bursts. Asset-backed securities including mortgage-backs, in contrast, are still at record spreads, but there is so little liquidity in that market that there is little there to encourage these spreads to contract. There are signs, though, that that some buying is starting to occur there.
In New Zealand, there may be small amounts of capital gain to come from its government bonds. In addition, corporate bond yields are still very wide. The falling cash yield should put at an end those questions as to why investors should not leave all of their money in the bank, although the volatility in markets will mean that a lot of cash is still maintained. Finally, the New Zealand dollar should be expected to fall even lower as our interest rate falls further and the soft commodity prices also detract.
To summarise, though, we all live in a sort of hope that Obama’s team can steer a steady path through some very turbulent times. The hope extends to New Zealand’s governance team that it can deal with the global responses, as well as our own peculiar issues.
Peter Lynn, CFA Head of Strategy| « Market Review: London February 2009 Commentary | Fund manager of the year nominees announced » |
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