Commentary – Quarterly bulletin, November 2009

2 November 2009

It’s hard to believe that the fallout from the biggest financial crisis and economic contraction in generations has been shaken off so quickly. But given the massive liquidity injection provided by the public sector perhaps we should not be too surprised. There will undoubtedly be market corrections ahead, but the risk now is of being out of equities during a period when they are likely to outperform most other asset classes over the medium to long term. It will, nevertheless, take some considerable time for the financial sector to recover from the crisis. Furthermore, the economies that were hit hardest will be slow to regain peak output and negative news along the way could trigger market volatility.

After a short pause in the summer, equity markets powered ahead in the third quarter.

This latest market rally may be more a consequence of the liquidity being provided by the central banks than of positive expectations for either economic growth or corporate profits. It is clear from an analysis of banking data that some of the liquidity has been finding its way to the bond market. Banks are using the opportunity provided by cheap funding to invest in ‘risk-free’ government bonds yielding a solid margin over their funding cost to generate profits and so help repair their capital strength. Liquidity’s link to the equity markets is less transparent but is still a driving force.

I maintain that equity market volatility will remain with us over the course of the next year and we may well experience bigger corrections than we had so far during the recovery. The key triggers in my view are likely to be corporate trading statements, as expectations are high for a substantial recovery in profits from this year’s depressed level, and the reversal of liquidity injections by central banks, whenever that occurs.

Emerging markets have recovered more quickly than developed markets since the bottom in the spring.

Relative to the world index they have reached the high watermark they hit at the beginning of 2008. As a group, emerging markets now represent 17%, by market value, of the world index as I demonstrate in the first chart. This compares with only 5% as recently as 2000 when the US market accounted for close to half the world market. Today emerging markets equate to nearly half of the shrinking share of the US. From a parochial point of view, emerging markets overtook the UK in 2005 and are now more than twice its share.

These trends are a reflection of economic and political realities.

Last year the International Monetary Fund estimated that developing countries’ GDP would exceed that of the developed world within five years. This year, the G20 group of finance ministers and central bankers from 20 “important” countries (including several from the developing world) have been getting more attention than the G8 summit of government heads from the industrialised world and Russia because of their alleged success in ending the financial crisis.

China is a major part of the emerging markets story.

It is widely expected to overtake Japan next year to become the world’s second largest economy after the US. Its foreign exchange reserves are still rising rapidly and currently amount to about £1,000 per head (all 1.3 billion of them!) or half a year’s earnings for the average Chinese worker. To put this in context, the UK’s foreign exchange reserves amount to only about a week’s wages of the average UK worker! China has become more assertive on the world stage in the past year, both in its political rhetoric and in flexing its financial muscle. It has been purchasing assets abroad largely to secure supplies of raw materials vital to its continued domestic economic expansion. We will no doubt hear a lot more about China in the years ahead.

Bond yields have continued to trend lower as gilt yields edge down and credit spreads narrow.
The Bank of England’s use of quantitative easing (along with similar monetary strategies in other countries) has contributed directly to this process. But the increase in liquidity has fuelled general demand for bonds, particularly those with lower quality credit ratings. Figure 2 shows the yield on gilts and the additional spread for AAA (highest quality) and BBB (medium quality) bonds over the past three years. At the start of the period the spreads were relatively normal and one can see the effect of the crisis as they ballooned in Q3-2008, reaching a peak in the spring of this year. They have recovered dramatically already but could still fall further to reach more normal levels.