• Contrary to the expectations of the gloom and doomsters, 2010 turned out to be a positive year. The global economy expanded by around 4.5 per cent, the world didn’t slip into recession and global sharemarkets generally rose.
• Sure, the year wasn’t without its problems. Investors fretted about a double-dip recession in the US, European debt, and an over-heating of the Chinese economy. But worse case scenarios were avoided.
• Australian interest rates rose over 2010 and probably will again in 2011.
• At face value, the Australian sharemarket disappointed. But in large part that’s because the Aussie dollar soared – the second strongest currency in the world over the year. In US dollar terms, the Australian
  sharemarket actually out-performed the ‘world’ index.

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Mark Burgess, incoming Chief Investment Officer at Threadneedle, looks ahead to 2011: “Our central case for 2011 is one of reasonable global growth led by emerging markets. Against this backdrop world equity markets look good value, particularly against government bonds. In addition, many companies have strong, healthy balance sheets and are sitting on large cash piles, having held back on investment during the recession. We expect corporates globally to start to use this cash to increase capex, raise dividends, buy-back stock or undertake merger and acquisition activity. We believe that emerging markets will continue to grow and outperform the rest of the world, helping to fuel demand for consumer goods and commodities.

“At the same time we must be mindful of the risks to this scenario. The credit crisis elicited a range of untested policy responses and we are yet to see the full consequences of these policies. The banking sector globally needs to continue to raise capital, which will restrain credit expansion and hence economic growth. In emerging markets there is the potential for growth to turn into a bubble and inflation to become a risk. Globally, markets remain fragile and any major shocks could cause volatility.

“This volatility should create opportunities for nimble, experienced investors with a proven ability to look through short-term noise and indentify long-term winners.”

INVESTMENT THEMES FOR 2011

Policy responses to remain a key driver of markets

Growing economic divergences highlight critical global imbalances that require intervention. The Eurozone is in crisis, China is tightening policy and the actions of developed markets threaten to spark currency wars. These issues all demand that policymakers adopt appropriate measures in a timely manner, yet policy response remains the single most difficult risk to assess. We believe that the ride will be bumpy but that policymakers will eventually arrive at the right place, allowing supportive fundamentals and ample liquidity to support asset prices.

• The European Central Bank must act urgently, as it has been reactive and fallen behind the curve in protecting the Eurozone. The ECB should recognise that policy must support the weaker economies and not simply be tuned to the mantra of “one size fits all”. This will necessitate a policy that is far too easy for stronger members, but the viability of the monetary union is at stake. We believe the ECB is likely to adopt some combination of lower rates, below-market rate loans to troubled economies, liquidity provisions and outright bond purchases.
• As QE becomes a more prevalent policy tool it is certain to evoke fears of competitive currency devaluation. There will likely be growing calls for capital controls in many developing economies reluctant to see an unwanted surge of liquidity into their economies. Such steps should not undermine the global growth story, but will likely stoke higher volatility across markets.
• China’s deflationary boom is turning inflationary, representing a paradigm shift in the economy at the heart of global imbalances. The ability of Chinese policymakers to tighten policy without rattling investors will require more skill than in past cycles.
• Ongoing de-leveraging continues to unleash powerful deflationary forces, which should allow developed economies to sustain modest growth whilst pursuing reflationary policies.

QE consequences

Quantitative easing has unleashed a wave of liquidity that must find a home. At the same time, it has stirred strong opposition in some quarters.

• QE2 is explicitly targeting asset prices and liquidity is likely to find its way into the areas offering the best value and potential returns. Currently this means higher risk assets such as equities. This is one of the reasons why we remain overweight in equities versus bonds.
• Specifically, emerging market equities and bonds are likely to be well supported. We may be in the early stages of a bubble in these assets.
• Subsequent waves of QE will become increasingly difficult to defend on the world stage. This could tip the current phase of currency devaluation into full-blown protectionism. Stocks with significant overseas earnings could suffer in this scenario (this is not our central case).

“Emerging market exposure is a consensus trade, but it can continue to reap rewards throughout 2011. It doesn’t make sense to stand in the way of this tide of liquidity.” Sarah Arkle, Chief Investment Officer (Vice Chairman from Jan 2011)

Stock picks: Sun Hung Kai, Barrick Gold

Untested policies

The credit crisis elicited a range of innovative and untested policy responses. This is likely to lead to ongoing volatility, rotation and unforeseen consequences.

• An important skill in 2011 will be the ability to look through short-term volatility to see the longer-term pricing anomalies.
• Ongoing uncertainty means that it will be more important than ever to be aware of risks in portfolios and ensure that all risks are understood and intended.
• Active management and stock picking are likely to add significant value in 2011.

“We are in completely uncharted waters here. Investors expecting a reversion to mean may be disappointed.” Jim Cielinski, Head of Fixed Income

The haves and the have-nots

Two-speed economies are developing at a global (emerging vs developed world), European (core vs periphery) and US level (skilled vs unskilled workforce). These distortions create socio-political tensions but also provide opportunities in a number of sectors.

• US unemployment remains high but in certain sectors, wage bargaining power is evident. When analysing companies, we will be emphasising their ability to retain talented staff without instigating wage inflation.
• With interest rates at all-time lows and QE2 targeting higher asset prices, employed, asset-rich consumers with mortgages should feel wealthier in 2011. This will support high-end consumer discretionary stocks.
• European banks with exposure to the periphery have been de-rated significantly. This creates the scope for a sharp rally if solvency fears are addressed decisively by the ECB. We remain underweight but continue to monitor the sector closely.

“You can’t take someone that was laying bricks on a building site in 2007 and put them into Google’s product development team. Specialist skills are in short supply and will be rewarded in 2011.” Cormac Weldon, Head of US Equities

Stock picks: Tiffany, Polo Ralph Lauren

The search for yield

We believe that inflation is not a risk in the developed world and that interest rates will be kept at historic lows in these markets. As such, government bond yields are unlikely to rise significantly and investors will seek income in higher-yielding areas.

• Emerging market and corporate bond valuations remain attractive relative to their improving fundamentals. We continue to favour these bonds over government issues in fixed income.
• Income stocks are likely to be in favour in equities. Moreover, companies that are reinstating or raising their dividends are likely to be re-rated.

“Why would I lend money to the UK government at 3.5% when I can get 5.1% with the prospect of dividend and capital growth from AstraZeneca?” Leigh Harrison, Head of Equities

Stock picks: AstraZeneca, Vodafone, BT

The emerging market consumer

Emerging markets will continue to produce superior growth in 2011 and growing wealth among consumers in these markets will support demand in a number of areas.

• We continue to invest in luxury goods stocks in Europe, where robust earnings growth has seen multiples decline despite rising share prices.
• More recently, we have expanded this theme into European premium auto stocks, eg BMW, where the valuation is attractive relative to its Asian joint venture partners.
• Banks in under-penetrated markets such as Indonesia and India are likely to attract capital as investors follow through the consumer theme.

“Luxury goods stocks were the first beneficiaries of growing emerging market wealth. The developing consumer credit cycle will create bigger ticket opportunities as this theme matures.” William Davies, Head of European Equities

Stock picks: BMW, Bank Rakyat

The return of capex

Companies have been very cautious in their investment plans in this cycle, preferring to maintain high levels of cash. Corporate balance sheets are strengthening and capital expenditure to depreciation ratios are at all time lows. We believe this trend will change in 2011.

• Improving economic confidence and high commodity prices are likely to drive increased capex in the extractive industries. Industrial stocks will be among the key beneficiaries.
• The replacement of ageing IT infrastructure at a wide range of companies will support earnings in the software and hardware sub-sectors.

“Mining equipment companies have been buffeted by changes in economic sentiment in 2010. They are attractively valued and there is scope for significant upgrades to earnings.” Simon Brazier, Co-Head of UK Equities

Stock picks: IMI, Komatsu

Mergers and acquisitions

Cash balances are high, valuations are attractive and companies will crystallise value in the market by undertaking earnings-enhancing corporate activity such as m&a. Meanwhile, private equity companies are under pressure to invest. Emerging market corporates are also likely to take advantage of currency strength to acquire footholds in companies in the developed world. This, together with share buy-backs, will drive a significant phase of m&a.

• Companies with unique assets, superior growth or access to proprietary technology will be among the main takeover targets.
• Management quality and valuation may not always be key drivers: small and mid-caps are likely to attract interest despite full relative valuations.
• Companies deploying cash in shareholder-friendly ways are likely to outperform as investors become more focused on the efficient use of capital.

“2011 could be the year when a household western name gets taken over by an emerging market rival.” Jeremy Podger, Head of Global Equities

Stock picks: Mid-cap resources, industrial companies

Commodity prices will remain underpinned

The outlook for commodity prices is positive, given the recovery in the world economy and the dominance of resource-hungry emerging markets in the global growth profile.

• Commodity-rich nations will continue to witness capital inflows, further strengthening FX positions and credit worthiness. This should support equity valuations and further spread tightening in fixed income.
• Companies using more expensive raw materials in their production processes will witness margin pressures.
• Rising commodity prices could be a source of inflationary pressure.

“Our growth forecasts imply additional demand of around 1.5m to 2m barrels of oil per day in 2011. If it becomes apparent that OPEC does not have sufficient spare capacity to meet this demand, the oil price could move sharply higher.” David Donora, Head of Commodities

• Mark Burgess becomes Chief Investment Officer from Jan 2011, when current CIO Sarah Arkle moves into her role as Vice Chairman.

• While Ireland has now been granted financial assistance from the IMF and European Union, concerns remain regarding Portugal and Spain.
• Spain is a bigger risk as it is nearly 12% of the euro area economy and European banks have a higher exposure to it. While its small savings banks are a risk, fortunately its public finances are in better shape.
• The economic back drop is more supportive than during the mid year Greek crisis as the German economy is holding up well, supporting the rest of Europe.

Introduction

Public debt problems in peripheral countries in Europe have been a recurring issue all year. Earlier this year the worry was Greece, in the last month it has been Ireland, and investors still worry about Portugal and Spain.

Back in May there was concern European sovereign debt problems would lead to another freezing up of credit markets triggering a global double dip back into recession. Our view was that – because global monetary conditions were very easy, the global economy was stronger than at the time of Lehman’s demise and policy makers were moving fast with Europe announcing a 720bn euro support package – it would be more like the Asian crisis of 1997-98. In other words, European public debt problems would be an ongoing source of volatility in markets, but largely contained. So far this has been the case with no signs of the credit or economic stress that came with the GFC. But recent developments highlight that risks remain significant.

Why the recent flare up?

The recent flare-up seemed to start with Ireland admitting  it would need to raise 31bn euros (or 19% of Irish GDP) to provide capital support for its banks and this was made worse by European proposals that bond investors may need to share in the cost of debt restructurings and more upwards revisions to Greece’s public debt. This saw public sector bond yields in Ireland pushed up to new crisis highs and investors start to worry again about Portugal and Spain, with a renewed sharp rise in their bond yields as well. Fearing the consequences of renewed market panic, European authorities encouraged Ireland to apply for assistance. It has now been granted with a 67bn euro support package as Ireland undergoes another round of austerity measures.

However, speculation has remained that Portugal will need assistance. The good news is Greece, Ireland and Portugal are small, comprising only 6.3% of the euro area economy. So providing assistance for Portugal as well wouldn’t be a major stretch financially for Europe and these economies aren’t big enough to have a noticeable impact on the European economy. The trouble would be if Spain were also affected.

Why the concern over Spain?

Spain, and even Portugal, are very different to Greece. Prior to the GFC Spain was running a budget surplus. Its budget deficit now seems to be coming back under control and its public debt to GDP ratio is below that of Germany and the US (see the table below). In short it doesn’t suffer from the solvency issues that trouble Greece.

The public debt blow out

* 32% if the bank bailout is included. Source: OECD, IMF, Eurostat, AMP Capital Investors

Rather, the main concerns appear to be that its weak economy (with 20% unemployment) will lead to further real estate losses and more problems for its banking sector (notably its small savings banks – which account for a big chunk of Spanish banking sector assets), all leading to a worsening in its public sector finances, particularly if bank bailouts are required. There is also a degree to which concern over Spain (and indeed other countries in Europe) is becoming self-fulfilling in that investor panic is driving higher bond yields making it harder for Spain (along with Portugal) to service its public debt, forcing it closer to the need for assistance. Higher public sector bond yields also push up private sector borrowing rates making life tougher for private sector borrowers as well.

A bailout for Spain may be feasible in the context of the 720bn euro facility announced in May, but only just, although some European officials have said the facility could be increased in size. But it would come with much bigger political conflict in Europe and raise more serious questions about the future of the euro.

A full blown crisis in Spain would also have a much bigger economic impact as it is 11.8% of the euro area economy and German and French banks have a much greater exposure to Spanish debt than they do to Greek, Irish and Portuguese debt. (Fortunately, US banks have little exposure to debt in troubled European countries.) The Spanish exposure of German banks is equivalent to 1.8% of their assets and for French banks it is 1.5% of assets.

Some grounds for optimism

As such, it is critical the contagion flowing through Europe ends soon, before tipping Spain over the edge. On this front there are some grounds for optimism. First, European authorities have got the message and have been moving quickly to provide assistance to Ireland, and would probably do so quickly in the case of Portugal as well if required. Second, real estate loan losses in the case of Spain are likely to be far smaller as a proportion of GDP (maybe adding 10% to the public debt to GDP ratio) than in Ireland, suggesting far less risk to the Spanish banking system. This is likely to be confirmed by another round of bank stress tests for Spanish banks that Spanish authorities have committed to provide. Thirdly, although worth keeping an eye, so far there is little evidence of panic in money or credit markets with spreads remaining well contained compared to the situation in 2008. This includes bank borrowing spreads in Europe. Finally, if the crisis doesn’t soon settle down we are likely to see renewed buying of Government bonds in troubled countries from the European Central Bank, an action that helped stabilise the Greek crisis mid-year.

More broadly it is interesting to note that unlike at the height of the Greek crisis in May-June this time around there has been less weakness in share markets. This in part likely reflects better economic news out of Europe generally. In May, the European PMI, a survey of business conditions, was starting to fall helping fuel worries of a double dip. However, in recent months it has surprised on the upside. In particular, this reflects strength in Germany and other northern European countries offsetting softness in countries with debt problems. See the next chart.

Germany seems to have been a key beneficiary of the crisis via a weaker euro. The overall business climate in Germany as measured by the IFO survey is at an all time high and Germany’s unemployment rate is at its lowest since 1992. (Germany is 27% of the euro area economy).

Source: Bloomberg, AMP Capital Investors

More broadly, business conditions indicators globally, whilst generally falling in mid year now appear to have mostly stabilised or improved (with the exception of Japan).

Source: Bloomberg, AMP Capital Investors

Concluding comments

There are several points worth concluding on. First, while European public debt woes will likely remain a periodic source of fragility in the global economy and volatility in financial markets, policy action should be enough to prevent them becoming a full blown crisis. Spain is worth keeping an eye on in the short term though. Secondly, just as the outlook for the $US is bleak, the problems with debt in Europe suggest the same in relation to the euro. The experience of Iceland, which now seems well on the way to recovery thanks in part to a plunge in its currency, highlights the benefit of allowing a weaker currency in response to debt problems. Thirdly, the public debt problems in Europe are of course part of a wider debt problem in major advanced countries including the US and Japan – which will act as a constraint on their growth for many years to come in contrast to emerging countries where public debt is not really an issue. Finally, while Australia has little public debt and has little trade exposure to Portugal, Ireland, Greece and Spain, it is affected via financial market and economic sentiment. Fortunately, it is more exposed to strongly growing emerging countries. The main risk for Australia would come if the European public debt woes led to a renewed credit crunch which would again make it more costly for Australian banks and businesses to raise funds offshore. So far though this appears unlikely.

]]> Key points

• While Ireland has now been granted financial assistance from the IMF and European Union, concerns remain regarding Portugal and Spain.
• Spain is a bigger risk as it is nearly 12% of the euro area economy and European banks have a higher exposure to it. While its small savings banks are a risk, fortunately its public finances are in better shape.
• The economic back drop is more supportive than during the mid year Greek crisis as the German economy is holding up well, supporting the rest of Europe.

Introduction

Public debt problems in peripheral countries in Europe have been a recurring issue all year. Earlier this year the worry was Greece, in the last month it has been Ireland, and investors still worry about Portugal and Spain.

Back in May there was concern European sovereign debt problems would lead to another freezing up of credit markets triggering a global double dip back into recession. Our view was that – because global monetary conditions were very easy, the global economy was stronger than at the time of Lehman’s demise and policy makers were moving fast with Europe announcing a 720bn euro support package – it would be more like the Asian crisis of 1997-98. In other words, European public debt problems would be an ongoing source of volatility in markets, but largely contained. So far this has been the case with no signs of the credit or economic stress that came with the GFC. But recent developments highlight that risks remain significant.

Why the recent flare up?

The recent flare-up seemed to start with Ireland admitting  it would need to raise 31bn euros (or 19% of Irish GDP) to provide capital support for its banks and this was made worse by European proposals that bond investors may need to share in the cost of debt restructurings and more upwards revisions to Greece’s public debt. This saw public sector bond yields in Ireland pushed up to new crisis highs and investors start to worry again about Portugal and Spain, with a renewed sharp rise in their bond yields as well. Fearing the consequences of renewed market panic, European authorities encouraged Ireland to apply for assistance. It has now been granted with a 67bn euro support package as Ireland undergoes another round of austerity measures.

However, speculation has remained that Portugal will need assistance. The good news is Greece, Ireland and Portugal are small, comprising only 6.3% of the euro area economy. So providing assistance for Portugal as well wouldn’t be a major stretch financially for Europe and these economies aren’t big enough to have a noticeable impact on the European economy. The trouble would be if Spain were also affected.

Why the concern over Spain?

Spain, and even Portugal, are very different to Greece. Prior to the GFC Spain was running a budget surplus. Its budget deficit now seems to be coming back under control and its public debt to GDP ratio is below that of Germany and the US (see the table below). In short it doesn’t suffer from the solvency issues that trouble Greece.

The public debt blow out

* 32% if the bank bailout is included. Source: OECD, IMF, Eurostat, AMP Capital Investors

Rather, the main concerns appear to be that its weak economy (with 20% unemployment) will lead to further real estate losses and more problems for its banking sector (notably its small savings banks – which account for a big chunk of Spanish banking sector assets), all leading to a worsening in its public sector finances, particularly if bank bailouts are required. There is also a degree to which concern over Spain (and indeed other countries in Europe) is becoming self-fulfilling in that investor panic is driving higher bond yields making it harder for Spain (along with Portugal) to service its public debt, forcing it closer to the need for assistance. Higher public sector bond yields also push up private sector borrowing rates making life tougher for private sector borrowers as well.

A bailout for Spain may be feasible in the context of the 720bn euro facility announced in May, but only just, although some European officials have said the facility could be increased in size. But it would come with much bigger political conflict in Europe and raise more serious questions about the future of the euro.

A full blown crisis in Spain would also have a much bigger economic impact as it is 11.8% of the euro area economy and German and French banks have a much greater exposure to Spanish debt than they do to Greek, Irish and Portuguese debt. (Fortunately, US banks have little exposure to debt in troubled European countries.) The Spanish exposure of German banks is equivalent to 1.8% of their assets and for French banks it is 1.5% of assets.

Some grounds for optimism

As such, it is critical the contagion flowing through Europe ends soon, before tipping Spain over the edge. On this front there are some grounds for optimism. First, European authorities have got the message and have been moving quickly to provide assistance to Ireland, and would probably do so quickly in the case of Portugal as well if required. Second, real estate loan losses in the case of Spain are likely to be far smaller as a proportion of GDP (maybe adding 10% to the public debt to GDP ratio) than in Ireland, suggesting far less risk to the Spanish banking system. This is likely to be confirmed by another round of bank stress tests for Spanish banks that Spanish authorities have committed to provide. Thirdly, although worth keeping an eye, so far there is little evidence of panic in money or credit markets with spreads remaining well contained compared to the situation in 2008. This includes bank borrowing spreads in Europe. Finally, if the crisis doesn’t soon settle down we are likely to see renewed buying of Government bonds in troubled countries from the European Central Bank, an action that helped stabilise the Greek crisis mid-year.

More broadly it is interesting to note that unlike at the height of the Greek crisis in May-June this time around there has been less weakness in share markets. This in part likely reflects better economic news out of Europe generally. In May, the European PMI, a survey of business conditions, was starting to fall helping fuel worries of a double dip. However, in recent months it has surprised on the upside. In particular, this reflects strength in Germany and other northern European countries offsetting softness in countries with debt problems. See the next chart.

Germany seems to have been a key beneficiary of the crisis via a weaker euro. The overall business climate in Germany as measured by the IFO survey is at an all time high and Germany’s unemployment rate is at its lowest since 1992. (Germany is 27% of the euro area economy).

Source: Bloomberg, AMP Capital Investors

More broadly, business conditions indicators globally, whilst generally falling in mid year now appear to have mostly stabilised or improved (with the exception of Japan).

Source: Bloomberg, AMP Capital Investors

Concluding comments

There are several points worth concluding on. First, while European public debt woes will likely remain a periodic source of fragility in the global economy and volatility in financial markets, policy action should be enough to prevent them becoming a full blown crisis. Spain is worth keeping an eye on in the short term though. Secondly, just as the outlook for the $US is bleak, the problems with debt in Europe suggest the same in relation to the euro. The experience of Iceland, which now seems well on the way to recovery thanks in part to a plunge in its currency, highlights the benefit of allowing a weaker currency in response to debt problems. Thirdly, the public debt problems in Europe are of course part of a wider debt problem in major advanced countries including the US and Japan – which will act as a constraint on their growth for many years to come in contrast to emerging countries where public debt is not really an issue. Finally, while Australia has little public debt and has little trade exposure to Portugal, Ireland, Greece and Spain, it is affected via financial market and economic sentiment. Fortunately, it is more exposed to strongly growing emerging countries. The main risk for Australia would come if the European public debt woes led to a renewed credit crunch which would again make it more costly for Australian banks and businesses to raise funds offshore. So far though this appears unlikely.

The post Greece, Ireland, etc…the ongoing European debt debacle appeared first on AdviserVoice.

Headline developments of the past week

• The contrast in global central banks was stark over the past week with those in weak countries such as the US, Japan and Europe leaving monetary conditions very easy and in the US actually easing further via more quantitative easing, whereas those in strong countries such as India and Australia actually raising interest rates. The move to QE2 in the US will result in a further huge boost to global liquidity which is positive for shares, particularly in emerging countries, and commodity prices and will reinforce the ongoing fall in the $US against commodity currencies such as the Australian dollar and emerging country currencies.
• The big event of the last week was of course the US Federal Reserve’s announcement of another round of quantitative easing (QE2), choosing to purchase an additional $US600bn of US Treasury bonds by the end of June next year with further moves subject to economic conditions. Will it work or will it just boost inflation? The claim by some that inflation will take off is nonsense. This will only be an issue once broad measures of money supply and credit pick up and capacity utilisation returns to normal but we have a long way to go to reach that point. The more substantive argument against QE2 is that the basic problem in the US is a lack of demand for credit. However, doing nothing is not an option. QE1 in 2008-09 does appear to have boosted the US economy. Moreover, QE2 could help the continuing US recovery by keeping borrowing costs low, boosting asset prices and hence having a positive wealth effect, keeping inflationary expectations positive and maintaining downwards pressure on the $US. The first three are likely to help support spending and a lower $US should help US exporters. With bond yields and the $US substantially lower and US shares up 17% or so since QE2 was first mooted in late August, it appears to have already had a positive effect.
• The US mid-term Congressional elections saw the Republicans regain control of the House of Representatives but fall short of control of the Senate. Republican control of the House of Representatives should help blunt some of the less business friendly policies that were emanating from the President Obama. More importantly, it may be good for the US if it leads to a more pragmatic and centrist approach from President Obama, much as occurred with President Clinton after the 1994 mid-term elections.
• In Australia, the Reserve Bank decided to act on its often stated tightening bias and raised the official cash rate by another 0.25% taking it to 4.75%. The Reserve Bank’s expectation that inflation will rise over the next few years points to further tightening ahead. However, the additional tightening that has flowed from the $A pushing through parity and bank moves to raise lending rates by more than the RBA rate increase suggest the next move probably won’t come until February and that the peak will be lower than otherwise would have been the case. Within a year’s time the cash rate is likely to have increased to around 5.5%.
• The RBA’s Quarterly Statement on Monetary Policy only served to reinforce its ongoing tightening bias. While inflation forecasts for this year were revised down, growth forecasts were revised up and the RBA still sees underlying inflation heading up to the top of its target range through the second half of next year as the boost to national income from high commodity prices pushes the economy up against capacity constraints.
• After a two week consolidation since first hitting parity, the $A broke decisively through the parity level against the $US on the back of the RBA’s rate hike and the Fed’s announcement of QE2. While gyrations in the $A will remain significant, the continuing strength in Australia’s terms of trade, further tightening in Australian monetary policy and an ongoing downtrend in the $US are likely to see the $A push up to around $US1.10 in the year ahead. Above parity for the $A will become part of the landscape, so get used to it!

Major global economic releases and implications

• US economic data was positive suggesting that the soft patch in growth may have ended and that, combined with QE2, the risk of a double dip back into recession has faded significantly. Both the ISM manufacturing and non-manufacturing conditions indicators rose in October, factory orders rose more than expected in September, weekly new mortgage applications rose further and most importantly payroll employment rose solidly in October led by 159,000 new private sector jobs.
• US profit reports remained very strong, consistent with continuing strength in productivity in the September quarter, and providing solid support for capex, employment and M&A activity going forward.
• European manufacturing conditions indicators rose in October with Germany remaining pretty solid.
• A further rise in Chinese manufacturing conditions indicators (or PMIs) and continuing strength in services sectors PMIs in October highlights the ongoing strength in the Chinese economy and points to a further tapping of the policy brakes in the months ahead. I have just spent the last week in China and have to say that there are no signs of the Chinese hard landing that was much feared earlier this year, let alone the bust that the China sceptics are always raving on about.

Australian economic releases and implications

• Australian economic data was mixed with a rise in indicators of manufacturing and services sector conditions, continued moderate growth in retail sales but flat house prices and another slide in building approvals. Quite clearly the 20% surge in house prices from the March quarter 2009 has now run its course and with affordability around record lows and set to worsen as mortgage rates rise further, house prices are likely to be flat to maybe even down slightly over the year ahead. However, the continuing undersupply highlighted by the latest fall in building approvals should provide a solid floor under house prices.

Major market moves

• Global shares are surging higher on a positive cocktail of better than expected global economic data and earnings news, the US announcement of QE2 and optimism that the Republican victories in US elections will lead to more business friendly policies. The surge in optimism has pushed US shares to new recovery highs and Australian shares decisively above the range they have been stuck in for a month with both markets up 3% over the last week. Asian shares which are likely to be key beneficiaries of the global liquidity boost flowing from QE2 were up even more with Hong Kong shares up 7.7% and Chinese shares up 5.1%.
• News of the increased supply of US dollars pushed the $US lower and this along with greater economic optimism pushed other growth trades such as commodity prices and the $A decisively higher.

What to watch in the week ahead?

• In the week ahead, the focus is likely to be on Chinese economic data for October. Activity indicators are expected to show ongoing solid, but not overheating growth. Housing indicators are likely to be soft. Higher food prices are likely to boost inflation to around 4%. However, this may well be the peak and benign non-food inflation and increasingly well balanced growth is likely to ensure that further policy tightening remains gradual and targeted.
• In Australia, employment data for October, due Thursday, is likely to show another decent gain in jobs and a fall in unemployment to 5%. Data for job ads are likely to remain solid, but Westpac’s consumer confidence index is likely to have fallen as a result on the latest rate hike and housing finance data for September is likely to have remained soft. The Government’s mid year economic and fiscal review is likely to see upside revisions to near term growth forecasts and a downwards revision to near term inflation forecasts.
• The G20 leaders’ summit is likely to provide nothing more than the usual hot air about commitments to market determined exchange rates and international cooperation. It may see more pressure on China to speed up the pace of Renminbi revaluation, but is unlikely to result in anything significant.

Outlook for markets

• Having undergone a consolidation in recent weeks, shares have now decisively broken out on the upside with further solid gains likely into year end and through next year. The global liquidity backdrop is getting even more favourable for shares underpinned by QE2 in the US, the soft patch in global growth appears to be over resulting in a return to investor confidence, the corporate sector is cashed up and this is likely to result in a further pickup in M&A activity, and shares remain very cheap relative to government bonds. Emerging market and Asian shares are likely to continue to outperform, but the key direction setting US share market is also likely to post solid gains. The average gain in US shares post mid-term elections has been 27% over the subsequent 12 months and we are now coming into the third year of the US presidential election cycle which is normally the strongest with an average post war gain of 18% pa. Against this backdrop, the Australian ASX200 share index is on track to push above the 5000 level by year end.
• After a period of consolidation since first hitting parity a few weeks ago the Australian dollar has broken decisively above it, and notwithstanding normal bumps along the way, looks to be heading even higher thanks to a falling US dollar, rising interest rates in Australia and high commodity prices. It is likely to settle around $US1.10 in the year ahead.
• Deflation worries, along with central bank government bond purchases in the US and elsewhere, are likely to keep bond yields low in the short term. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

• The Federal Budget deficit stood at $54.8 billion in 2009/10 (4.2 per cent of GDP), an improvement of $2.3 billion on the estimate made just four months ago at the time of the May budget. GST receipts hit record highs in 2009/10, up 9.2 per cent on a year ago.

• The budget is clearly on track to surplus over the next 2-3 years through a combination of strong economic growth and discipline in restraining spending.

• Federal Treasury was again too conservative in its budget and economic forecasts. For the past six years, Treasury has under-estimated the budget position on average by $7 billion.

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Headline developments of the past week

• While the risk of a double dip back into recession may be waning, the prospect of sub-par growth in key developed countries suggests that another round of global reflation looks to be on the way, via more quantitative easing (or QE2), with both the US Federal Reserve and the Bank of England indicating that they are considering it if needed to support their recoveries. In the US it seems that deflation is becoming a bigger concern for the Fed and with the Fed’s 2011 growth forecasts likely to be revised down to below levels necessary to cut unemployment we think the odds favour QE2 getting underway in November. This will mean more US dollars sloshing around putting more downwards pressure on the greenback. But with Japan, the UK and ultimately Europe likely to be pumping up the supply of their currencies as well this weakness is more likely to show up in continued strength in Asian currencies, gold and commodity currencies like the $A.
• The past week has seen more messages from the Reserve Bank to the effect that higher interest rates are likely to be necessary to keep inflation under control – this time from the Governor and the Minutes from the last Board meeting. The clear message from Governor Stevens was also that the regional differences across the country – and by implication the two speed economy – are not an impediment to further interest rate hikes. As a result, market expectations have now moved into line with our expectation for an October rate hike.
• All the talk of QE2 in the US and more rate hikes in Australia is helping propel the $A back closer to parity against the $US. Its worth noting that the norm for the $A over the last century up until early 1982, was for the $A to trade above parity versus the $US. This includes the early 1950s when the terms of trade was about as strong as it is now. Back then one Australian dollar bought $US1.12.
• There was good news in the US from the National Bureau of Economic Research which determined that the recession that began in December 2007 officially ended in June last year, making it the longest recession since the Great Depression. Of course the share market anticipated – as it usually does – the end of the recession back in March last year. But while the contraction may have ended, this is not to say that the economy has returned to normal and certainly most Americans would still see the country as being in recession.

Major global economic releases and implications

• US economic data was mixed. Housing activity related data was generally flat to slightly better with housing starts and permits rising, existing home sales up 7.6% in August and new home sales and the National Association of Home Builder’s conditions index tracking sideways. Weekly mortgage applications to purchase a home fell but have been essentially stable for the last three months now. The basic picture is that housing activity related indicators have stabilised after their post first home buyer tax credit slump, but they are yet to stage a decent recovery. A survey of home prices fell for the second consecutive month in lagged response to earlier weakness. Jobless claims rose after four weeks of falls. On the positive side though, durable goods orders were much stronger than expected and a leading index of growth rose in August consistent with a continuing recovery in the US.
• In Europe, industrial orders fell by more than expected, manufacturing and services conditions indicators fell in September and consumer confidence was steady in September. While Germany continues to do a bit better than the rest of Europe with a rise in business conditions, a fall in unemployment and better consumer confidence, worries about peripheral countries continued with Ireland’s GDP contracting 1.2% in the June quarter. In the UK, housing data was weaker, with a dip in mortgage approvals in August and a third consecutive decline in the Rightmove house price index.
• Various public holidays saw a quite week across Asia. Japan saw softness in super market sales but stronger than expected readings for coincident and leading economic indicators and the all industry activity index and strong machine tool orders.

Australian economic releases and implications

• In Australia, the Australian Bureau of Agricultural and Resource Economics raised its forecast for commodity exports, both volumes and prices, this fiscal year and the Westpac/Melbourne Institute’s Leading Index rose in July.

Major market moves

• US and European shares received a strong boost on Friday from stronger than expected durable goods orders in the US, an unexpected rise in German business conditions and good news on corporate earnings, resulting in solid gains over the past week as a whole. Asian shares were generally higher, but Japanese and Australian shares were softer partly in response to an earlier negative lead from Wall Street.
• Public sector bond yields fell on expectations that the Fed will buy more treasuries.
• Commodity prices continued to rise with the gold price rising to a new record high on the prospect of the Fed flooding the world with more US dollars and base metal prices rising further on the back of falling inventories and the weak $US.
• Higher commodity prices, more talk of easing in the US and more talk of rate hikes in Australia all worked to push the Australian dollar higher.

What to watch in the week ahead?

• In the US, various regional surveys suggest that the key ISM manufacturing conditions index is likely to slip slightly to a reading around 54.5 (from 56.3 in August). This would still be consistent with continuing recovery though. Consumer confidence is likely to have fallen slightly and the Case-Shiller house price index is likely to be weak. Data for construction spending, personal spending and the third estimate of second quarter GDP will also be released.
• China’s manufacturing conditions survey, or PMI, is likely to show that conditions remain stable consistent with overall economic growth around 9%.
• In Japan, the Tankan business survey for the September quarter is likely to show a softening in conditions and the outlook.
• In Australia, August building approvals data is likely to show a modest rise of around 1% and private sector credit growth is likely to remain soft. As foreshadowed in the Minutes from the last Board meeting the RBA’s latest Financial Stability Review is expected to show that the Australian financial system remains strong.

Outlook for markets

• After very strong gains in shares since their August lows, shares are at risk of a correction in the short term. However, while near-term uncertainties remain, shares are likely to see further strong gains into year-end and through 2011. Shares are very cheap relative to government bonds, investors are still very bearish which is positive from a contrarian perspective, and once it becomes clear that the US/global recovery is continuing (albeit slowly) there is likely to be a big reversal of investment flows – out of government bonds and back into shares.
• After an 8% gain since late August which has taken it to a 26 month high, the Australian dollar is vulnerable to a correction. However, further gains in the value of the $A are likely on a six to 12 month horizon as it becomes clear that the global recovery is continuing and commodity prices are remaining strong, the US Federal Reserve embarks on more quantitative easing and Australian interest rates continue to rise well above global rates.
• Double dip and deflation worries along with the prospect of more central bank government bond purchases in the US and elsewhere are likely to keep bond yields low in the short term, but medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

Key points

• The sub-par recovery in the US, Japan and Europe and constrained fiscal policy most likely means that we will see another round of global policy reflation, centred on quantitative easing (or printing money).
• This will be bad news for G3 currencies, but good news for Asian currencies and gold. And it will likely also help stimulate the next asset price bubble.
• The $A is likely to head higher as Japan and the US boost their money supplies and the RBA continues to raise Australian interest rates.

Global Reflation Mark II

Another round of global monetary reflation is likely getting underway with the US Federal Reserve and the Bank of England indicating that they are now considering additional monetary easing and Japan undertaking its own easing in moving to push the value of the Yen lower. This has major implications for foreign exchange markets, the gold price and the next asset price bubble.

The key driver is the sub-par nature of the recoveries in the US, Japan and Europe and the inability of fiscal policy to respond further given already high public debt levels. With interest rates at or close to zero, central banks look to be turning to another round of quantitative easing. Technically this involves expanding the size of the central bank’s balance sheet and basically involves using printed money to buy securities, so as to increase the quantity of money in the system. Increase the supply of something and its price normally falls!

• Following its September meeting the US Federal Reserve has indicated that it is considering more monetary easing if needed to support the economic recovery and push inflation back up to levels more consistent with price stability. And since the Fed Funds rate is close to zero this effectively would mean another round of quantitative easing (or QE2), which would involve using printed money to buy Treasury bonds. With US growth now below the level necessary to stop unemployment from rising (which is at least 2.5% pa) and the Fed likely to revise down its 2011 growth forecasts, it’s likely to engage in quantitative easing following its November meeting. Market speculation is that the Fed is considering undertaking another $US1 trillion of asset purchases (which is the equivalent of 7% of US GDP). Coming on the back of $US1.3 trillion in Fed asset purchases in 2008-09 this would result in a further sharp rise in the size of the Fed’s balance sheet (see the chart below) and another big increase in the supply of US dollars.

Source: US Federal Reserve, AMP Capital Investors

Market expectations of QE2 in the US and a resultant increase in the supply of US dollars have seen renewed downwards pressure on the $US.

• The Bank of England has also indicated that it is considering more quantitative easing.
• Tiring of seeing the Yen move ever higher in response to a weakening $US, Japan has responded by starting to buy US dollars and by leaving the increased supply of Yen in the economy in what is called unsterilized intervention. As such it has essentially engaged in quantitative easing itself. Currently it has only spent Yen2 trillion but purportedly has Yen35 trillion available, which would be about 7% of its GDP and hence roughly match the potential US easing.
• So far Europe has merely complained about the Bank of Japan’s intervention and it is still reaping the benefits of the weaker euro seen over the December to May period. But with the euro rising sharply again in response to a weaker $US and fiscal tightening likely to impact next year there is a good chance that it will also be forced into quantitative easing next year.

The end result is likely to be an increase in the supply of US dollars, Yen, British pounds and euros and a race down in each of these currencies, with the $US leading the charge.

Such “beggar thy neighbour” policies or “competitive depreciations” will no doubt result in worries about all sorts of things, in particular inflation and trade tensions. Inflation is a risk but as with QE1 it isn’t going to happen until people start spending and spare capacity, evident in circa 10% unemployment in the US and Europe and idle factories, is used up. Right now the bigger risk is deflation, so G3 central banks can afford to take risks with printing more money.

Another obvious issue is: will it work?

Quantitative easing operates by injecting more cash into banks, lowering mortgage rates and corporate borrowing rates (as government bond yields fall) and pushing the exchange rate lower (at least against countries not doing the same). But so far US banks have not leant much of the cash out from the first round of quantitative easing (ie the money multiplier remains low) and mortgage rates are already at record lows. The counter of course is that QE1 probably did prevent a worse outcome, banks will be able to further rebuild their balance sheets, further falls in mortgage rates will allow more US homeowners to refinance their loans at lower rates and the $US will at least fall against non-major currencies providing a further boost to its exports. And Fed Chairman Ben Bernanke feels that he at least has to try!

So what will it all mean?

There are several implications from another round of monetary easing.

First, it means another boost to global liquidity which should at least support growth, if not provide an additional boost to growth going forward.

Second, it will likely be positive for share markets and other listed growth assets as it was through last year following QE1.

Third, it will be bad for G3 currencies – first the $US, but also the Yen and ultimately the euro as its economy lags the US and it is forced to do the same.

Fourth, Asian and other emerging market currencies are likely to remain key beneficiaries as their central banks engage in tightening and the relative supply of their currencies falls relative to US dollars, Yen, British pounds and euros. China’s move last week to allow a faster appreciation in the Renminbi will likely help accelerate the rise in Asian currencies.

Source: Bloomberg, AMP Capital Investors

Fifth, the increase in the supply of US dollars, Yen, British pounds and euros (the latter next year) will be good for gold as investors seek a safe haven from falls in major paper currencies. This explains why gold has recently broken out to a new record high, even though inflation remains benign. The chart below shows that while the gold price has come a long way over the last decade it is still well below its inflation adjusted peak of 1980, when gold rose above $US2,000 an ounce. It will likely head up to a similar level over the next few years.

Source: Global Financial Data, AMP Capital Investors

Sixth, commodity currencies such as the Australian and Canadian dollars are also likely to be key beneficiaries. Talk of an additional boost to the supply of US dollars via quantitative easing is coming at a time when the RBA is signalling more interest rate hikes and commodity prices are strong all of which are positive for the $A. All the talk of QE2 in the US is helping propel the $A back to parity against the $US. The chart below showing the value of the $A since 1901 serves as a reminder that the post float period of the $A which saw it slip below parity is an aberration. The norm up until early 1982, was for the $A to trade above parity. This includes the early 1950s when the terms of trade was about as strong as it is now. Back then one Australian dollar bought $US1.12.

Source: Thomson Financial, RBA, AMP Capital Investors

Finally, another surge in global liquidity will help fertilise the next asset price bubble, the seeds of which have already been sown in the bursting of the last. This could well be in emerging markets or commodities. And to the extent that emerging market countries intervene to resist appreciation in their currencies it will only add to the boost in global liquidity.

Australia

September 20    Reserve Bank Governor speech    Foodbowl Unlimited Forum Luncheon in Shepparton

September 21    RBA Board minutes (September 7)    Minutes of the last board meeting

September 21    ABARE commodity forecasts      ABARE’s ‘Australian Commodities’ publication

September 24    Financial accounts (September quarter)    Includes data on household financial wealth

Overseas

September 21    US Housing starts (August)                 Recovery will remain modest given high inventories

September 21    US Federal Reserve rates decision     No change in rates, with the focus on the wording of the statement

September 23    US Leading index (August)                 A modest 0.1pct increase is expected

September 23    US Existing home sales (August)       Economists tip a 7pct rebound after the 27.2pct slump in July

September 24    US Durable goods orders (August)    Orders are consolidating after lifting 10pct over the year

September 24    US New home sales (August)              New home sales hit record lows in July

The big picture

• Is there one particular theme or issue that dominates the radar screen? Unfortunately it is never that easy. There are always a few balls in the air and that is certainly the case at present.
• Probably the biggest issue is whether the US economy is headed for a double-dip downturn. Everyone seems to have their views on the topic, including renowned investor Warren Buffett. At present all the economic data indicates that the US is merely consolidating after a ‘V-shaped’ recovery in late 2009/early 2010. But clearly the issue is a watching brief given that unemployment is still high and the housing market remains over-supplied with stock.
• Certainly the issue of a ‘double-dip’ will be in focus in the coming week with the US Federal Reserve policy- making committee to assess the state of the economy and determine if more stimulus is required. Some analysts are betting on more ‘quantitative easing’ – buying government bonds to inject cash in the economy – and that speculation is putting downward pressure on the US dollar.
• A weaker greenback is good news for the US economy, serving to stimulate the export sector. And a weaker US dollar also tends to lead to higher commodity prices as it improves purchasing power for European and Asian buyers. But the opposite side of the equation – strength in other currencies – may pose problems for other countries. The Aussie dollar has certainly soared over the past week, putting pressure on tourism, exporters and manufacturers.
• There are also a number of other issues to watch. One is that listed companies are paying more attention to dividends. In the latest profit-reporting season in Australia, CommSec calculated that 83 per cent of companies paid a dividend with 40 per cent lifting dividends compared with a year ago. Companies have high cash reserves at present, and if they remain reluctant to put them to work, there may be more recourse to issuing share buy- backs, lifting dividends or paying special dividends. In the US, Cisco Systems will pay a dividend for the first time and Microsoft has announced that it will borrow to fund a higher dividend payment.
• And one other event to keep a watch on is the US mid-term elections, held on November 2. Analysts believe that this could actually be good for stocks, calculating that the S&P 500 has risen on average by 13 per cent during the year after mid-term elections. And if gridlock eventuates this could be even more positive for stocks. Gridlock is where one party has control of the White House and another has control of Congress, creating the risk that little in the way of new legislation gets advanced.

The week ahead

• A quiet week is in prospect on the Australian economic calendar with housing data to dominate in the US. In addition the US Federal Reserve holds its latest interest rate setting meeting with the jury still out on prospects for a double-dip recession.
• In Australia, the Reserve Bank Governor is scheduled to deliver a speech on Monday with minutes of the last Reserve Bank Board meeting to be released on Tuesday. Also on Tuesday, the Government’s main commodity forecaster, ABARE, will release its quarterly Australian Commodities publication containing the latest commodity price forecasts. And on Friday the Financial Accounts will be released.
• Whenever the Reserve Bank Governor speaks, investors and analysts stand to attention. But few are expecting any hints on interest rate settings. The Reserve Bank will probably wait until the next inflation data at the end of October before deciding its next move. Certainly domestic economic data remains very patchy and the same can be said for the global environment with China in strong shape, the US stagnating and European countries taking different growth paths.
• The Reserve Bank Board minutes will probably come to the same conclusions and the commentary is unlikely to signal any urgency in changing the stance of policy.
• The commodity price forecasts will be keenly awaited by those investors focussed on prospects for the resources sector. But the Government will also be a keen observer as each time ABARE changes its forecasts, it seems to trigger changes in the expected tax take of the proposed mineral resource rent tax.
• The data release of note in the coming week is the Financial Accounts. This publication will reveal statistics like the cash holdings of superannuation funds, the proportion of listed shares held by foreigners and the financial wealth held by Aussie households.
• In the US, the focus is squarely on the health of the housing sector, although we use the term ‘health’ quite lightly. The latest housing starts data is released on Tuesday with existing home sales on Thursday and new home sales figures are slated for release on Friday.
• Apart from the housing market data, the Federal Reserve hands down its interest rate decision on Tuesday with the leading index slated for release on Thursday and durable goods orders on Friday.
• Overall economists expect slightly more positive results for the housing market in August after dreadful results in July. Admittedly the home buyer tax credit adversely affected these July figures, but it is clear that housing activity remains depressed.
• Housing starts probably lifted 1.5 per cent in August. Interestingly, with inventories already so high, a bigger lift in starts may appear encouraging but it wouldn’t be sustainable. In addition, existing home sales are tipped to have risen by over 7 per cent in the month, but this follows a fall of over 27 per cent in July. And new homes sales are expected to have lifted 7.5 per cent from record lows.
• The Federal Reserve meeting should prove an interesting event given the mixed views that currently exist. But the Fed is unlikely to be in a rush to inject any more stimuli into the economy. The best thing it can do is to leave current policy settings in place and focus on the positive aspects of the economic recovery.

Sharemarket

• You could hardly call the Australian sharemarket “cheap” at present. Currently the historic price-earnings ratio (PE ratio) stands at 15.95, above the long-term average of around 15.00. Going back a year ago after the profit- reporting season, the PE ratio hovered in the 13-14 range. It was in a similar range after the earnings season in 2007. And in the intervening year of 2008, the sharemarket was even cheaper with a PE ratio of 10-11 times – admittedly it became even cheaper as investors were focussed on the earnings outlook rather than history.
• With the PE ratio slightly above average at present and companies reluctant to provide guidance on earnings, the Aussie sharemarket will continue to find it hard to make forward progress in the short term. What is needed is a more upbeat view on recoveries in the US and Europe. Our end year forecast for the ASX 200 remains at 4800.

Interest rates, currencies & commodities

• There is currently a lot of focus on the Aussie dollar, but how strong is it really? CommSec has assessed 120 currencies and found that the Aussie is the 13th strongest against the greenback since the start of the year. The Colombian peso is on top with gains of 12 per cent, followed by the Malaysian ringgit (up 9.5 per cent) and Japanese yen (up 9 per cent). The Aussie dollar has actually made modest gains of around 4 per cent since the start of the year. At the other end of the spectrum, African and eastern European currencies have recorded the biggest losses against the US dollar over 2010, but the Euro is also one of the biggest losers, down 12 per cent.
• Australian motorists are certainly one of the beneficiaries of the high-flying Aussie dollar. Not only has the Aussie lifted from US88 cents to US 94 cents in recently weeks, but the oil price has retreated over the past month or so from just above US$80 a barrel. As a result, the average retail price of petrol has fallen to an 11-month low with motorists saving around $17 a month compared with three months ago.

Key points

• Shares normally go through a tough patch in the second year following a bear market low. This can reflect worries about monetary policy tightening or worries about a double dip back into recession.
• This is certainly the case in the US this year and has affected most global share markets.
• The US today appears to resemble the performance of the Australian economy and share market following its early 1990s financial crisis and recession.
• Double dip fears were also a big worry in Australia in 1992, contributing to a difficult year for the local share market at the time. However this gave way to better conditions in 1993. The US may be following a similar path.

Introduction

The second 12 months after a bear market ends is often rough, compared to the big rebound that normally occurs in the first year. This has certainly proven to be the case this year. However, it is interesting to note the parallels between the weakness in the key direction setting US share market this year and the experience of Australian shares in 1992, when Australia was struggling to recover from its worst financial crisis since the Great Depression and worries about a double dip back into recession were intensifying. But if the Australian experience 18 years ago is any guide, US shares are likely on track for much better conditions next year

Bear market recoveries

The tables that follow show the experience following post war bear markets in US and Australian shares. While the first 12 months typically sees strong gains – 39% on average in US shares and 28% on average in Australian shares – the next 12 months are often much tougher – with 8% average gains in US shares and 6% average gains in Australian shares.

The tougher performance in the second year usually reflects either worries about a tightening in monetary policy once the economic recovery is underway or worries about a double dip back into recession. In the US, Europe and Japan this year it has largely been a case of the latter, with concerns about a “double dip” back into recession intensifying in the last six months or so.

Post bear market recoveries, US shares

Source: Bloomberg, AMP Capital Investors

Post bear market recoveries, Australian shares

Source: Bloomberg, AMP Capital Investors

Double dip worries in the US along with policy tightening have also weighed on share markets in China, Asia and Australia.

Parallels with Australia in the early 1990s

However, it’s interesting to note that the US economy and share market seems to be going through something very similar to what the Australian economy and share market went through in the early 1990s. Back in the early 1990s Australia was struggling to throw off the effects of a severe recession that in part had its genesis in excessive corporate lending by the banks in the late 1980s. The share market fell 32% from a high in September 1989 to a low in January 1991, which ushered in a recession through 1990-91. While the share market rose by 39% between January 1991 to January 1992 and the economy started to recover from September 1991, through 1992 worries about a double dip back into recession intensified as:

• the recovery was initially anaemic – with growth averaging around 2.8% in the first year – and jobless;
• unemployment continued to rise, not peaking until it reached 10.9% in December 1992, nearly 18 months after the economy had started to grow again;
• commercial property prices continued to collapse (office values fell around 50% over 3 years) and corporate failures threatened the financial system, with the failure of numerous financial organisations – eg, Estate Mortgage, Pyramid Building Society, all the state banks in Western Australia, South Australia and Victoria – and concerns that two of the top four banks might go bust. This was Australia’s equivalent of what the US has been going through over the last few years; and
• as a result of the financial crisis private sector credit continued to fall in 1992, even though the recession had ended the year before.

Reflecting worries about a double dip back into recession, the Australian share market fell sharply into a low in November 1992 and its weakness is evident in the 9% fall evident over the January 1991 to January 1992 period in the second table above.

There are numerous parallels between Australia in the early 1990s and the US today: the size and scale of the financial crisis, the collapse in property markets, the anaemic jobless recovery and the continuing contraction in bank lending.

The chart below shows a comparison between the Australian share market over the four and a half years from July 1989 and the US share market from July 2007 to the present.

Source: Bloomberg, AMP Capital Investors

So far the US share market is tracking the experience of the Australian share market back in the early 1990s quite closely with a sharp bear market, strong gains in the first year of recovery, followed by weakness in the second year on the back of “double dip” fears. And since the short term swings in the Australian share market are (irrationally) heavily influenced by the US share market, it has been following the US today even though its economy is in far better shape now.

Interestingly, if the relationship continues to hold then, while further weakness is possible in the next few months, the Australian experience of the early 1990s would suggest strong gains over the year ahead if double dip fears fade and the recovery continues as occurred in Australia back then.

Of course the US today is more fragile than Australia in the early 1990s, which had much lower levels of public and household debt and was a much smaller country so gained immensely from a global economic recovery. So the US recovery is unlikely to be as strong as seen in Australia in 1993 and the returns from US shares are likely to remain constrained and volatile in the years ahead. Nevertheless the severity of the Australian financial crisis at the time is instructive in reminding investors there can be a continuing recovery after such events and once it becomes clear a double dip back into recession is not happening there is plenty of upside for share markets over the year ahead.

In this regard, the tables on the first page include what happens in the third year after a recession ends, and it can be seen to be somewhat mixed – flattish in the US but up solidly in Australia. Out of interest over the January 1993 to January 1994 period the Australian share market rose by 46%.

Conclusion

The parallel between the anaemic and fragile post financial crisis US economic recovery of today and of Australia in 1992, suggests the current double dip worries in the US could give way to better conditions in the US in the year ahead. This is particularly the case with share markets now very cheap, notably against government bonds where yields are now very low.

The inaugural ‘Financial Services Council Chief Investment Officer Investment Index’ shows Chief Investment Officers (CIOs) are mildly optimistic about the performance of Australian and international investments over the next 12 months, but are concerned about short and long term risks related to the slowdown of the US and European economies.

The quarterly Index, which is based on CIO responses from a sample of Financial Services Council members, measures 11 from a range of -100 to 100, where a score of 0 is considered neutral.

John Brogden, CEO of the Financial Services Council, said: “This new Index provides an insight into the factors weighing on the minds of Chief Investment Officers of Australia’s leading investment companies.

“While they expressed some confidence about the Australian economy, they are concerned about the risks presented by debt and deleveraging in Europe and the US.

“Overall, CIOs describe the investment environment as complex and fragile,” Mr Brogden said.

In terms of specific asset classes:

• Australian and international equities are expected to be the best performers over the next 12 months;
• International property is expected to perform better than Australian property; and
• Fixed income assets, both domestically and internationally, are not expected to perform as well as other assets.

The Index shows that while sentiment is on the whole mildly optimistic, CIOs have concerns about risks within the US and European economies. Their concerns are predominantly related to the fiscal positions of those regions and the austerity measures that have been taken.  They also have concerns about the risk attached to Australia’s increasing reliance on Asia, in particular China.

Looking to the longer term (five years), CIOs consider debt and deleveraging to be the most significant potential sources of risk.  Inflationary pressures are also considered potentially significant as economies move out of recession.