RCM Global Strategic Outlook
Q2 2008
Economic Outlook
The big risk to the global economy is stemming from the dislocations in the money and credit markets, which have their roots in the housing market crisis in the US and selected other economies. Of course, the biggest calamities are being felt in the US with combined losses to the global financial system which could easily mount to $600 or $800 billion. While it is certainly easy to paint a gloomy picture for the global economy, one should also be aware of the fact that policy makers are not sitting on the sidelines. The longer the downturn lasts, the more severe the situation becomes, the more policy makers are willing to apply conventional and non-conventional measures to stem the crisis. In that respect, central banks around the globe have already provided liquidity to the banking sector in times of extraordinary stress. Hence, we think that the more bad news that comes to the surface, the more likely it is that rescue packages will be forged. We are probably in the endgame of this financial crisis.
Bond And Equity Markets
Both bond and equity markets have started to assess the US and global economic outlook similarly. Equities, especially bank stocks, have corrected sharply, and government bond markets have soared, while credit spreads widened substantially. We reiterate our position that near-term pressure in the equity markets may continue and the bond markets may continue to perform positively. However, the longer the financial markets crisis lasts, the more likely it will be that policy makers apply conventional and non-conventional measures to avert a negative growth spiral and a financial markets meltdown. Down the road, these measures will most likely stimulate the economies and provide a floor to risky assets. Our proprietary indicators for the US have already started to pick up some time ago. Hence, we would recommend looking at lower equity prices as potential entry points rather than using any spikes in prices to sell into.
Asset Allocation
Consistent with our cautious view on equities tactically, we also underweight equities relative to bonds in the tactical balanced portfolio. Equities tend to underperform when markets are pricing in a massive fall in central bank rates (not a rise in rates). However, as rates and rate expectations have already fallen substantially in the US, we would not be surprised to see the bottom of equities’ underperformance reached soon. In addition, bond markets are currently already discounting a massive growth slowdown. They are quite expensive on our numbers, supporting our call to overweight equities versus bonds for a medium to longer investment horizon. With respect to FX, our long-term cautious view on the dollar has turned out to be correct.
Thematic Piece: The Carry Trade Revisited
While carry trades have recently fallen from the radar screen we know that over time they work very well and eventually their time will come again.
The phenomenon underlying the carry trade is perhaps one of the best-researched anomalies in financial markets; it is called ‘forward rate bias’. The forward rate bias, simply put, means that currencies of countries with higher local yields tend to fall less against currencies of countries with lower local rates than implied by the forward rate.
We think that the existence of the forward rate bias can also be justified theoretically: first, forward currency rates are hardly a good proxy for future spot rates. Second, on average, high carry is likely to overestimate the future decline (if any) of the currency with higher rates, and the future rise of the currency with the lower rates.
Global Outlook
If the US consumer starts to retrench, how serious will the global impact be? Needless to say, this looks to be a good question, for at least three reasons: the US economy has not experienced a consumer-led recession since 1990-1991; households’ debt stands at an alltime high representing 1.4 times disposable personal income; households’ financial deficit still represents 2.3% of disposable personal income. Not surprisingly, this question has caused many jitters in financial markets since last summer.
Yet, to a certain extent, we already know the answer to this question: the impact should be diluted, if the last four years are any guide to the future. For although one cannot rule out lags nor non-linearity in the linkages between the US economy and the rest of the world, some other observations lend credibility to the assumption that the US economy is no longer big enough to pull the whole world down.
US Outlook
Over the past two quarters, the economic consensus has moved decidedly into a mildly stagflationary frame of mind. On the Chicago Fed’s own monthly proxy for real GDP momentum, there is no longer any question that the US has entered a recession. In contemporary mainstream, macro-policy intervention is primarily monetary, not fiscal, and monetary policy works primarily by managing and manipulating private sector agent expectations. If this is right, one way we can tell whether the Fed (or Congress) has done enough is if the expectations of US consumers have begun to stabilise and improve. In fact, the expectations component of the monthly University of Michigan consumer survey has provided a reasonably good guide to real consumer spending, a major element in determining real GDP momentum. The bad news is we’re not yet at prior business cycle troughs for consumer expectations. The good news is that we’re not that far from prior troughs either.
Continental Europe Outlook
There has been much speculation about the possible spillover effects from the fallout of the US housing market crisis and the credit and money market tensions to the European economy. While the concerns are justified to some extent, it is worth having a closer look at this hypothesis.
The channel through which the US housing crisis could actually impact the Continental European economy is threefold. First, weaker US demand would have a direct, negative impact on trans-Atlantic trade. Second, the stronger euro is reducing the competitiveness of Europe. Third, European financial institutions are holding US Asset Backed Securities (ABS) on their books, which now have to be written off to a significant extent.
U.K. Outlook
Over the last three months, with no obvious resolution of the credit crisis, the probability of a recession in the UK has risen. Understanding the cause of the slowdown is reasonably easy. The hard part, because of the UK’s high exposure to housing, is assessing its magnitude and longevity. In summary, our central view is that the UK will narrowly avoid a recession, with GDP growth being in the region of 1.5% for 2008 and little obvious recovery in 2009. Indeed, we are likely to see a number of years of sub-par growth as the necessary rebalancing of the economy could be a long and uncertain process.
Japan Outlook
The March business survey exhibited a severe deterioration of management sentiment and a weak business environment outlook: the financial sector credit crisis and the fear of it leading to a recession in the US, high oil prices, and the recent sharp appreciation of the Japanese yen are unlikely to help prospects in the short term. The number of new job offers is now declining, and the ratio of jobs to applicants remains below 1.0x. Now that employment conditions are loosening, a recovery in consumption is unlikely.
The potential upside in Japan rests with a number of factors: even if it takes time, the markets may decide in 2H 2008 that the credit crunch in developed economies is finally under control. If this combines with a recovery from the Japanese regulatory hangover of 2007 and the 2H 2008 still holds prospects of continued demand from emerging markets for advanced materials and capital goods, then the markets could rally.
Asia-Pacific Outlook
It has been 10 years since the Asian crisis began to unfold, and today Asia is now in a much healthier economic position than when it was heading into the crisis. With the exception of India, net private capital flows are much lower, and while currency reserves are still very high, they are buttressed by current account balances that are now very positive. Despite the solid secular fundamental strength of most Asian economies, we expect the effects of slowing demand in the US to finally take traction in Asia this quarter. Despite the significant growth and scale of intra-Asian trade in recent months, Asian economies are not likely to escape the effects of slowing demand from the US and will, therefore, have to expand domestic stimulus measures in the coming quarters.
Commodities Outlook
Since the last GSO, commodity price indices accelerated in parabolic fashion despite a weakened global economy and the possible onset of recession in the United States. Then, suddenly, two weeks ago the Commodity Research Bureau (CRB) commodity prices corrected by 7.9% in a week – the biggest weekly decline in 28 years. This year’s parabolic rise in commodity prices and this dramatic reversal now has many asking: ‘are the commodity markets the latest bubble?’.
Past performance is no guarantee of future results. This document contains the current opinions of RCM and such opinions are subject to change without notice. This document has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
