Back in December, when we put together forecasts for the coming year, we predicted that 2009 would be a 'long, hard slog' in economic terms. The world was set to experience a deep recession, which might prove to be protracted. However, we foresaw no repeat of the great depression.
Instead, we predicted that the global economy would expand at its slowest rate since the World War II, and many of the advanced economies would contract by one per cent or so. But we did not expect a deep fall in activity. And we did not expect the slowdown to last through to 2010.
So how are things looking now a month on? We remain comfortable with this overall story. However, it is clear that the hit to economic growth towards the end of last year was bigger than we had pencilled in. It also looks to have been more synchronous in nature. No significant economy seems to have avoided the sharp slowdown, and many have seen an outright contraction in activity.
In particular, Asia – especially the countries that are heavily dependent on global trade – has been hard hit. Japan looks as if it may have shrunk by two-three per cent in the fourth quarter of 2008 alone. While just 10 weeks ago most observers expected Japan to flat-line this year, now many agree with our own forecast that 2009 will see a fall in Japanese GDP of at least two per cent.
All in all, we have found it necessary to trim our growth numbers for 2009. And as a result, it now looks fairly likely that the global economy will shrink a little this year. Nevertheless, it is not all doom and gloom – we still feel that recovery could get under way as soon as the second half of 2009 in the US, although it may be 2010 before the UK or Japan can join in.
Banking fears resurface
Alongside the gloomy economic news of the past month, many major financial institutions have reported big hits to their earnings. These have come from the slowdown and associated declines in market values of hard-to-value financial instruments, such as mortgage-backed securities, in recognition of the fact that housing markets are dropping at a steeper rate again in many countries , including, critically, the US.
Talk of President Barack Obama's approach involving the creation of 'bad banks', in which to hold the troubled assets, may well improve the situation. But, as so often, the devil will be in the details. Especially important will be the split between the public and private sectors if the 'toxic' assets recover any value.
Policymakers pull out stops
Although policymakers are still struggling with the implications of the credit crunch for their banking systems, they have pulled on all possible policy levers to help bolster demand. Thus, although both GDP and inflation are likely to be weaker this year than seemed likely at 2008-end, interest rates may also end up being slashed more aggressively. Many central banks may also find more unusual methods to support activity. Generally, these efforts are being directed on three broad fronts. Quantitative easing is one: using public funds to help lower yields on other instruments, not just short-term rates. This may, for example, involve the authorities printing money and using it to buy government bonds of longer maturity.
Another strategy is fiscal easing. Before Christmas, several large countries were lukewarm, to put it mildly, about whether they should join the fiscal easing planned by the likes of the US, China and Britain – particularly the Germans and the Japanese. Now, less than six weeks later, everyone has joined the party; typically to the tune of 1.5-2 per cent of GDP this year and, in many cases, next too.
Finally, authorities around the world are working overtime on more unorthodox ways of turning the situation around. These measures potentially include giving households vouchers to spend; providing financial incentives to replace durable goods; lending directly to the non-financial sector; and providing credit guarantees to companies.
Recommendations on track
To complete our update, we need to consider the themes that we thought would play out this year. The general message, thus far, is that things are progressing much as we expected. Taking our recommendations from December 1, we update as necessary:
Get long, or stay long, the futures strip until spring. Almost every major central bank is sounding and acting more dovish than formerly, and markets have moved accordingly. Of course, with short-term rates now close to zero in several cases, there is not much juice left in the trade. But as rates are clearly not heading higher anywhere for some time, we see little downside risk to this recommendation.
Look to get long investment-grade credit quite soon. Our analysis last year that markets were overly pessimistic suggested that investment-grade credit was more attractive than equities, but that it might be too optimistic to expect it to perform in first quarter. So far, so accurate. We remain comfortable with the idea that investors should be looking to get long this asset class pretty soon.
Equity turnaround may have to wait until mid-year. With so much bad news in the price, and the possibility of new US policy initiatives convincing investors of better times ahead, the case for getting long equities is stronger than it was. For those who agree, we suggest only a short-term bet. For those with longer horizons, averaging in, so as to start building a more forthright exposure to equities, is worth considering.
Stay defensive on countries and sectors for now. We remain very happy staying long 'defensive' countries – such as the US and Switzerland – and hence short the more aggressive ones, such as the Brics. Likewise, the same applies to our sector calls.
Commodities to follow the economic cycle. We thought it more likely than not that oil (and other commodity) prices would come under a little downward pressure during the first semester of this year. So, we suggested a small underweight. So far that has turned out to be right, although the volatility in oil prices means that it is tough discerning much of a trend. Oil prices will probably only move meaningfully higher once demand stabilises.
Real estate has quite a bit further to fall. One asset class we called well last year was real estate – covering both the price of housing and commercial property. In both cases, we expected more pain ahead, and recommended staying underweight. We are very comfortable continuing to ride that trend for now, as we expect the turnaround to be a sluggish affair.
So far in 2009, the world has turned out much as we suspected it would – a 'brutal' recession, that will entail a contraction of GDP in the first half of the year, at a minimum, and associated downward pressure on prices. Policymakers will have to use every tool in their toolbox to turn things around. But, ultimately, they should manage to get the economy back off its knees again.
Once the shoots of economic recovery appear, riskier asset classes such as equities should recover somewhat. But that may be a story more for the second half of the year, or perhaps if we are lucky, the second quarter. Meantime, investors should remain defensive, but look to investment-grade credit as the first place to add risk.
- Michael Dicks is Managing Director and Head of Research and Strategy at Barclays Wealth. The opinions expressed are his own