Market Microscope

Alan Saunders, Chairman of our Investment Committee, reviews the Global economy

Markets have recovered and there is a two-way debate on the outlook

There has been much debate as to the timing and shape of the economic recovery when it comes but there is little doubt that the recovery in equity markets this year has been V- shaped. The rally at the end of last year was quickly snuffed out and escalating panic over the problems of the banking sector and its impact on the global economy led to a steep fall which established new lows for this bear market. The FTSE 100 fell from 4600 to 3500 but a rally commenced at the start of March which took the index back over 4400 by June.

The extreme early pessimism reflected a real concern that the global economy was spiralling into a debt-deflation world not unlike the 1930s, with the losses in the banking sector seemingly beyond resolution despite the response of the authorities in cutting interest rates, expanding budget deficits and attempting to recapitalise the banks. Extreme risk aversion affected all asset classes including equities, with falling oil and commodity prices and with sterling being sold heavily. Fear of the unknown dominated and any remaining bulls gave up.

Now markets have recovered to year-end levels and there is a two - way debate on the outlook. The catalyst was the G20 meeting in London which gave comfort that countries were cooperating. In addition, central banks and regulators were at last showing a stronger grip, with proposals to take on bank bad debts and to inject equity into their balance sheets while introducing measures like quantitative easing, i.e. increasing the money supply to avoid a severe contraction in economic activity.

So-called Green shoots have been seen...

The UK is thought to have weaker prospects than most because of consumers' love affair with housing but there are some stabilisers that will soften the slowdown. The sudden collapse of sterling has been alarming but will be a support to exports while falling commodity prices will help disposable income. Undoubtedly, confidence has been shaken and rising unemployment will not help turn sentiment round quickly. Company profits will suffer accordingly.

There is now a growing view that the recession, while brutal, could be shorter-lived than the consensus believed only a few months ago. So-called green shoots have been seen which at least suggest we are out of the steep down phase in economies. Much of this was due to destocking which gets reversed as companies realise they are short of stock. What we lack at present is any comfort that a recovery can be sustainable and that consumer spending and investment are on a positive trend.

The UK has been in the teeth of the storm of course and government finances have deteriorated at an alarming rate so that it will take years to reduce the debt burden. Curiously, though, our economy is doing no worse than others, helped perhaps by the decline in sterling and there is already talk of a recovery by year-end. The housing market will be critical and there are some signs that house prices are levelling off. Inflation has been dropping fast, which helps real incomes.

In the down phase of the market cycle, the only performing asset was gilts which reflected extreme risk aversion and a flight to quality. Now, gilts have sold off over concerns of the size of budget deficits, future inflation risk and the likely over-supply of gilts. In contrast, corporate bonds have begun a recovery as spreads begin to narrow in sympathy with the recovery in equities.

Looking ahead, it seems likely that we are past the worst, both for the economy and for markets. That said, markets have had a good run and a period of consolidation is due. We could expect sideways markets over the summer until we have more evidence that the recession is ending. Too much is perhaps now being taken for granted, as there are still serious risks to contend with. If the evidence becomes more substantial, then we can expect higher market levels by year-end though we are unlikely to climb back to the levels of last year for some time.