Financial markets forecast: Bottoms up

The actions taken by the US Government and Federal Reserve appear to have stabilised the US financial sector, as well as confidence in the economy. Economic indicators are pointing towards improved activity, consumer and business confidence, while the US stock market has bounced 50 per cent from March 9, 2009.

The monetary and fiscal stimulus provided to the global economy is of an unprecedented scale. The level of debt in the US and level of deficit-driven growth is concerning. Will these factors lead to hyperinflation in the US? Maybe, but it would not be my immediate assumption.

I believe we are in a period when most economic indicators will show a statistical recovery from the low base recorded over last the quarter of 2008. This will give the appearance of a V-shaped economic recovery. Coupled with the fact that analysts were too negative on earnings prospects and are now upgrading their profit expectations, equity markets should maintain an upward bias over the balance of 2009.

Beyond 2009, the outlook for equity markets is extremely difficult to call. But I do believe the shape and duration of recovery will differ between Australia, Asia and the US.

My impression of the consensus view on the shape and duration of economic recovery in the US is that it will be W-shaped and short in duration relative to other cycles. I am a firm believer that consensus is generally wrong. The rationale for the initial V-shaped recovery turning to a W is as follows:

• the consumer-driven growth over the last 30 years will stall as consumers rebuild savings and reduce debt;
• weaker asset prices have subdued consumers’ ability and willingness to use home equity to finance current consumption;
• lack of job creation and high unemployment is also a factor depressing consumption and the ability of the economic recovery to be sustained;
• federal debt levels limit the ability of the US Government to cushion weaker economic growth;
• economic growth momentum and power is shifting to Asia;
• holders of US treasury bonds are becoming nervous about the US fiscal position;
• despite the prospects of stronger domestic economic activity, the US dollar remains weak. The consensus view is that a highly accommodative monetary policy, high debt levels, high budget and current account deficits will keep the US dollar under selling pressure.

Areas where that W-shaped US economic recovery and weak US dollar view could be wrong:

• the recovery outside of the US becomes stronger and more sustainable, thereby improving US export prospects. China, India, Russia, Japan and Latin America enjoy sustainable growth;
• the US consumer spends at a reduced rate that is offset by higher business and government investment;
• US multinationals bring a higher portion of their global profits back onshore;
• the US Government makes progress on cutting the budget deficit, perhaps exiting the expensive military activities in the Middle East;
• consolidation of industries as a result of the global financial crisis (GFC) delivers improved profits for survivors. The US banking/investment banking industry would be a good case in point;
• the cost cutting during the GFC leads to a larger profit recovery than consensus;
• stabilisation of the equity and property markets together with historically low interest rates results in higher consumption and improved confidence;
• the nature of fiscal expansion means the lagged impact of some policies announced 12 months ago will be felt for another two years in many cases; and
• progress on reforming the US budgetary outlay process may deliver bigger efficiency gains over time.

We are currently in the consensus camp with our view that the US economic recovery is likely to be short in duration and that balance sheet repair at the consumer and government levels will be a constraint to economic growth. However, the stock market is not expensive in our view (13.5-14.0X 2010), with upside risk to earnings.

In our view, the Federal and the US Government have enough tools to avoid hyperinflation. Clearly there is still excess capacity in the US economy in both the labour and manufacturing sectors. Further, many industrial companies have outsourced capacity to countries outside the US where costs are lower.

The consolidation of the banking sector and tighter regulation is likely to result in a more rational allocation of loans than the easing of lending policies of the 2002 to August 2007 period. Tighter credit provision will not encourage hyperinflation. Commodity price rises driven by demand from Asia may be a source of higher inflation if we see synchronised global growth.

Will economic activity and the stock market collapse when monetary and fiscal stimulus ends? Not in my view.

Monetary policy is likely to be tightened gradually with reference to prevailing economic conditions. If the economy weakens, monetary tightening will be stalled.

Using Japan as an analogy, loose monetary and fiscal policy for a decade did not result in hyperinflation. This was a concern at the time those policies were originally implemented. The US and Japan are different in the sense that Japan started its downturn in 1990 with high personal savings and minimal government debt, which is different to the US today.

The other key difference is the asset bubble in Japan was more extreme than that what has occurred in the US.

In our view Asia has a better chance of enjoying a more sustainable economic and stock market recovery compared to the US.

The factors that support this view are:

• Asia has massive savings, particularly at the Foreign Exchange Reserve position;
• Asia went into the global financial crisis (GFC) with relatively modest debt levels;
• Asia enjoys secular, internal driven growth from
• infrastructure spending requirements and healthy consumption;
• economic growth in Asia is likely to run at a rate double that of the US or EU;
• Asian companies are under geared following the last currency crisis of July 1997;
• Asia has a population base of over three billion, with rising income levels;
• Asia is leveraged to any ultimate improvement in global economic activity via Asia’s export industries;
• valuations on Asian equities, while no longer cheap by historical measures, may develop over time and the price earnings ratio (PER) premium versus MSCI World reflects better growth prospects;
• many Asian countries have their interest rates influenced by the US. Low US interest rates is providing significant stimulus to the Hong Kong property market;
• weaker oil prices have helped a number of Asian countries that are net importers;
• the financial crisis has eased the inflationary pressures that were building in Asia prior to August 2007;
• signs of structural changes in Malaysia and Japan may prove turning points for their equity markets.

Australia’s fortunes are increasingly related to Asia. Given our positive view on Asia, we believe Australia will benefit from a period of rising trade activity with Asia. In our view, the Australian economy and equity market is likely to benefit from Asia’s strong economic growth.

The factors supporting this view include:

• low levels of Australian Government debt versus US/UK;
• a strong mandated superannuation savings base;
• a well capitalised, albeit less competitive banking sector;
• significant capital raisings have reduced gearing levels and default risk for banks;
• government policies have cushioned the economic downturn;
• there is further scope to reduce the Australian corporate tax rate;
• the equity market has already discounted those companies that were over geared going into the global financial crisis and running dubious strategies;
• there is still significant cash on the sidelines that will ultimately re-enter the equity market;
• like Asia, cheap equity valuation is no longer on offer in Australia. However, earnings have proven more robust than the consensus view of 2008;
• and in sectors where consolidation/deleveraging is occurring, such as banking and real estate investment trusts, profit leverage may surprise as activity returns to more normal levels.

The composition of growth in Australia may move towards investment and away from consumption as government spending and monetary stimulus abates. Another equity market collapse is highly unlikely in my view. Loose holders and over-geared holders have already been exposed and shaken out.

Usually at turning points in economic cycles, PERs on equities would be at least five price earnings points above long-term averages, reflecting the earnings upside potential over a three to four-year period.

In Asia, US, Europe and Australia this is not the case. Markets are already pricing in the possibility of economic recovery not being sustained. The actual risk may be that global economic recovery is sustained and we move into a period of synchronised stable growth.

If you think back to what happened in Australia at the end of the 1980s, we had a period of excessive lending, banks went bust, credit was turned off for a period, the real economy collapsed. What followed that period was lending standards were tightened, state and federal governments cut their debt levels, interest rates moved down and Australia is still enjoying a 17-year run without a recession.

If you asked most economists what chance Australia had of delivering 17 years of consecutive growth in 1992, you would have received very long odds. Beware the consensus of negativity at the bottom of cycles.

Mark Newman is chief investment officer at K2 Asset Management.