MLC Market Watch

By MLC Market Watch Team

7 Aug 2009

What shape recovery?

Industry commentators claim to be seeing signs of recovery, but is it too soon to be calling the end of this generation’s big bad bear?

In the May minutes of the Reserve Bank Board, several signs of a turnaround were noted including:

signs that the rate of contraction in the US economy had slowed
global equity markets rising sharply over the past two months
improved conditions in global credit markets
appreciation of the Australian dollar and emerging markets economies
an increase in Australian business confidence
domestic terms of trade still at historically high levels, with export volumes holding up better than expected
signs the economic stimulus applied by the Rudd Government were supporting demand in the Australian economy, and
signs the Australian economy was likely to record better outcomes than most other advanced economies in 2009 and 2010.

Based upon this, and other economic data, the Board decided against lowering interest rates.

So does all this mean that we’re officially out of the woods? The answer is, it seems, not yet.

The right time to buy?

While the economic data provides encouraging news it does need to be viewed in the context of what is, for the most part, a severely weakened global market. In particular, investors may unwittingly be overly optimistic, due to the overwhelmingly positive market climate we’ve been fortunate enough to operate in for much of the last couple of decades, where investors have been conditioned to consider buying when the market dips. This feeling may also be encouraged by indicators which suggest that the Australian economy will escape the hardship that other countries such as the UK are going through.

Investors face two potential scenarios which may describe the current investment landscape.

all the risk is priced in, and now is the time to buy, or
some of the risk is priced in, but there may still be some way to fall and the risk-reward trade-off is not attractive.

Unlike previous recoveries, this potential recovery cycle has to contend with a massive debt overhang. US dollar denominated debt totals around $12 trillion or around 20% of world GDP. At some point, this will need to be dialled back for the recovery to be sustained.

This is why investors, at this point, should be careful to separate the good investment opportunities from the ones that should be avoided, even if the magnitude of the market fall may suggest that everything is better value.

And the assistance of a skilled expert, like your financial planner, to identify those buying opportunities is paramount to exploiting the emerging opportunity.

Shaping up

So what shape will the recovery take? While it is difficult to be too definitive or prescriptive about the nature of the recovery, there are three potential outcomes for global economies.

Perhaps the most feared outcome is the ‘L’, best understood by the example of the Japanese economy. In the 1990s, several monetary policy errors led to a prolonged stagnation in economic growth.

This may be the least likely scenario because central banks and policy makers around the world have acted swiftly in the wake of the Global Financial Crisis to avoid a repeat of this situation.

On the flipside, a ‘V’ shaped recovery, distinguished by a fast decline followed by a sharp and immediate upswing, is possible though, unfortunately, it is probably also not very likely. While China has taken steps to stimulate it’s economy, growth is still declining because US demand is shrinking.

A ‘U’ shaped recovery, then, seems the most likely path for the economies of the world. This is best understood as a period of stagnation followed by a slow and steady return to more positive conditions.

So what does this mean for investors?

In essence, what this means is that given the fundamental driver of asset returns is economic growth, a slow recovery for asset values should be anticipated. However, it would be prudent for investors to adopt modest expectations of a recovery as the issues facing the global economy and financial systems are deep and serious.

While investors are understandably keen to recover the value of their investments, it’s important to keep the news of a global recovery in perspective and prepare for what may be a longer, steadier ride to growth than expected.

However, it’s not all bad news. There are still significant opportunities for investors to purchase quality assets at beaten down prices. And there are positive signs the global markets are finally on the mend, with the Australian economy out of the blocks relatively early. Note though that it is hard to determine whether this recovery is sustainable.

Understanding just what to make of the news about investment and economic markets which seems to change every day can be confusing, even frustrating.

However your financial planner is the best person to clarify how changes in the market environment are likely to affect you, and what the best strategy is to stay on track for your long-term objectives.