Global and economic outlook

While the downturn is currently running at full speed, there is clearly a sign of hope for the global economy, as policymakers are stepping up their efforts to stabilise economic activity. In a crisis like the current one, the only pocket that is deep enough to provide funding for financial institutions is the government sector – not the private sector. Massive liquidity injections by central banks are also supposed to stimulate credit growth. However, so far banks have primarily hoarded any additional liquidity and only to a small extent passed on lower official rates to companies and households. What is still missing is a stimulus for the demand side of credit. While actual fiscal packages so far have been rather moderate, packages that are currently under discussion are starting to be of appropriate size to compensate for the lack of private-sector demand. We think that all these measures will at some point help to stimulate a turnaround in economic activity. Will it be this year? Probably. Our proprietary leading indicators have already started to turn up, both for the US and for the EMU. Will it be a forceful or a shallow recovery? Rather the latter.

Bond and equity markets

World equity market performance in Q4 of last year as well as for 2008 overall was one of the worst on record. Developed equity markets were down around 40% in 2008 and emerging equities by more than 50%. Such a substantial loss in equity prices is a very rare event. Since 1896, US equities (we only have long-term time series for the US market) have only fallen by more than 40% in the early 1930s, i.e. during the Great Depression, and in 1942, post the Pearl Harbor attacks.

With respect to government bonds, near-term cyclical weakness could continue to be supportive for bonds. However, government bonds are very richly priced and have performed very strongly already: the one-year drop in the 10-year government bond yield is historically a three–standard deviation case.

For 2009, we are optimistic about equity markets, but our conviction is weaker compared to our multi-year investment view. In addition, a deteriorating economic environment could continue to create uncertainty among investors, leading to continued high market volatility at least over the coming months. We therefore only recommend a neutral weighting of equities relative to bonds for 2009.

Asset allocation

We have not changed our sector and style positions during the past quarter. Overall, our recommendation remains growth stocks in times of an economic and earnings growth deceleration.

Regarding sectors, we stick to our underweight of financials globally but think that the bulk of underperformance is behind us. Defensive sectors should be overweighted due to their noncyclicality for the time being. We prefer pharma over staples on valuation grounds. Within cyclicals, we think that capital expenditure (capex)–related sectors are better value than consumer discretionaries and less vulnerable to a slowdown in US consumer demand. We are inclined though to trim capex-related industrials and IT to underweight or neutral, as economic data continue to weaken.

US outlook

Among the challenges arising in 2009 are the following: household savings are rising while business investment is falling, thereby damaging profits; rising household savings are not lowering the interest rates that matter to investment; and the trade deficit is proving intractable despite a recession. Monetary policy has moved on to unconventional measures, and we expect that a full court press from fiscal policy will help shift the US off the debt deflation pathway it was entering by the end of 2008. Our belief is that attempts by the private sector to de-leverage will be met with an enormous policy response, with the price paid being a re-leveraging of the public sector.

Continental Europe outlook

The last quarter of the year saw a rapid deterioration in both economic activity and confidence over the prospects for 2009 in general. There can be no doubt that the collapse of Lehman Brothers in early September caused much of the European economy to experience a dramatic slowdown of activity and trade, as banks sought to manage and limit their counterparty risks. Whilst managements reacted swiftly in many cases to the speed and globalisation of the problem, politicians and the European Central Bank (ECB) in particular were slow to appreciate the scale of the challenge.

UK outlook

As the global environment has deteriorated further, (with the obvious exception of Iceland) few countries have performed as poorly as the UK. The most obvious manifestation of this has been the exchange rate. In times of financial crisis the UK has had a long history of devaluing its currency in the hope of stimulating recovery. Some devaluations have been more considered than others, but in general they have all had a degree of success in eventually restoring the UK’s financial position relative to its peer group. For example, by 1997 the pound had fully recovered the levels seen immediately before its humiliating departure from the European Exchange Rate Mechanism five years earlier.

Japan outlook

The Japanese economy could not avert the huge influence of the failure of Lehman Brothers, which made the real economy worse through de-leveraging of financial institutions and the collapse of the credit market. July–September GDP annualised growth was -1.8%, and negative growth is expected to continue over the next several quarters. Both private consumption and the corporate sector’s activity are getting weaker. Exports and production are also slowing as global demand shrinks. One positive factor for corporate earnings could be a fall in commodity prices. Most manufacturers suffered from high raw materials costs and struggled to pass the cost on to customers. Now that the prices of oil, grain, various metals, and other upstream products have plummeted, the burden of raw material costs has declined.

Asia-Pacific outlook

The beautiful, clear blue skies along the coast of southern China into Q4 2008 were an ominous signal of slowing global demand – a harbinger of the end of the period of the Asian export-growth model. With Asia’s export markets now simultaneously broken, Asia stands at a pivotal political and economic crossroads: between regression toward a continued and detrimental reliance on the now-broken mechanisms that brought its current aggregate wealth or progression that leverages those reserves to move Asian economies into the 21st century.

Commodities outlook

The bull market in ‘real’ commodity prices in the past decade was by far the most extreme in history in both amplitude and duration over a single cycle. It took more than six years for that record commodity bull market to unfold. When it reached its peak in the middle of 2008 there was a universal agreement that this bull market was due to a new era for commodities characterised by a super cycle in global commodity demands and unprecedented constraints on supply across many commodities. The super-cycle demand story was all about China and India as unstoppable engines of rapid economic growth with an insatiable need for raw materials. Now, a mere six months later, we have had the biggest commodity bust in history.