The second quarter of 2009 saw the return of risk appetite and, in the case of some markets, the biggest quarterly rally in 50 years. Other risk assets also rose, bond spreads narrowed, and the long end of the bond market, as well as commodities, rose as deflation fears started to subside. This followed unprecedented policy action on both the fiscal and monetary front over the past few quarters. Market participants increasingly started to talk about ‘green shoots’, and banks – in the US in particular – agitated to return government monies. And with talk of a return of ‘big bonuses,’ one might have been forgiven for thinking that all was on the mend.

Markets may have gotten ahead of themselves and temporarily forgotten about some of the causes of this crisis; previous and newly emerging structural imbalances will not be easily digested.

For starters, there is the significant private debt overhang in large parts of the Organization for Economic Cooperation and Development (OECD) economies, which will prove a drag on future private consumption. While the savings rate in particular in the US has started to rise, the combined effects of higher unemployment rates and a still moribund housing market will counterbalance this effect for the foreseeable future. It took six years, for example, for the UK housing market to start recovering from the peak of the previous boom in 1989 and another four years for home prices to recover all their losses. And without a doubt, the nature of this crisis is worse.

These imbalances in the private sector are now being compounded on the public side, with governments globally engaging in unprecedented fiscal stimuli, which will lead debt-to-GDP ratios to rise above 100% of GDP. Rightly, this is starting to concern markets, with questions being raised about possible supply overhang and exit strategies – with upward pressure on yields in the meantime. Similar concerns relate to the monetary stimuli, with fears that once the velocity of money starts to pick up, the massive liquidity injections will have inflationary consequences, again putting upward pressure on yields.

The one bright spot continued to be some of the emerging markets, in particular China, India, and Brazil. None of these economies actually entered recession, with consumption remaining robust and government fiscal expansion further cushioning the global recession. The suggestion that these economies could decouple from the global cycle has been proved right retrospectively. China in particular has scope for continued fiscal expansion, should the need arise. Consequently, these emerging markets have outperformed the rest of the world.

I continue to discount the spectre of outright deflation, although the combined effects of rising unemployment, a significant global output gap, and debt overhang will delay the resurgence of inflation over the next 12–18 months. Beyond that, moderate inflation will form an important part of any exit strategy, addressing both the private debt overhang as well as government deficits.

With all that said, I fear that the dawning realisation that the crisis will be prolonged and any recovery arduous and difficult will lead to an erosion of recent market gains. We have hence trimmed our tactical overweight position in equities to neutral. Companies are telling us that they are almost ‘flying blind’ – which makes good fundamental analysis even more important.

Being in the right stocks, sectors, and market segments will yield significant returns in the continued volatile environment. I do not believe that we will retest the March market lows, so any significant market correction should be viewed as a buying opportunity, in particular in the case of China and commodities.

Andreas Utermann

Global Chief Investment Officer, RCM

Global Strategic Outlook - 3rd Quarter 2009