BT: Global recession risks 'not insignificant' (24 Sep 2008)

MONEY MATTERS
Global recession risks 'not insignificant'

Uncertainties likely to continue for a while as the market has not fully priced in the possibility of a slowdown

By CHEW SOON GEK

SINCE June there has been a noticeable slowdown in the world economy. The trends have intensified and are likely to last into 2009. A collapse of world growth is not expected, but we do expect the slowest growth figures for the G-7 since 1981-82.

Global economic growth is expected to slow from 4.7 per cent in 2007 to 3.8 per cent in 2008 and decrease further to 3.2 per cent in 2009. The deleveraging of the US financial system will limit lending and liquidity. Rising unemployment and negative wealth effects are expected to affect the US, Europe and Japan. A simultaneous slowdown in G-7 import demand should have a significant influence on the rest of the world, increasing the risk of a global recession.

Emerging markets are expected to demonstrate resilience despite the headwinds from the developed world, due to continued high domestic demand and strong competitiveness. Their contribution to world growth is expected to be the highest ever in 2008 and 2009 at about 80 per cent of the total increase.

The switch from inflation to recession fears due to the changed fundamental outlook is led by a banking crisis and wide-spread deleveraging. This has affected almost all asset classes during the past few weeks - elevated interbank borrowing costs, widening credit spreads, falling government bond yields and commodity prices. Equity markets corrected and the US dollar underwent a massive recovery.

The weakening of global economic activity and a moderation of inflation is increasingly priced into the market when we look at inflation-linked bonds and commodity prices. However, the risks of global recession are not insignificant and we believe the market has not yet fully priced in the possibility of such a scenario. As a result, the potential for setbacks still exists and uncertainties are likely to continue for a while. Overall, patience, discipline and risk management will be the most important ingredients for a successful investment strategy.

Rates and inflation outlook

On a three-month and 12-month horizon, a stable US Fed funds rate of 2 per cent is expected. While the weak housing market and economy might warrant further easing, the need to bear on future inflation expectations and to avert a dollar crisis is likely to keep rates flat for longer. US inflation is expected to fall from 4.5 per cent in 2008 to 2.8 per cent in 2009. Euroland inflation should rise to 3.6 per cent in 2008 and is expected to turn out lower in 2009 at 2.5 per cent. In Euroland, with a slowing economy that was previously under-estimated, we expect the refinancing rate to be 50 basis points lower at 3.75 per cent in 12 months. For Japan, no action is expected on a 12-month horizon, with short rates at 0.5 per cent. In Asia, inflation is expected to fall from 7.8 per cent to 5.5 per cent in 2009. There is scope for monetary easing in the coming months as inflation eases in some countries, with China having been the first to call for a reduction in rates.

While the cyclical downswing should result in lower inflation in 2009, longer-term risks of higher secular inflation beyond 2009-10 are on the cards: profits compared with wages as a share of corporate profit are at a historic peak, pointing to a likely shift in favour of wages, structurally high commodity prices and the fading out of disinflationary forces from globalisation. The 'Goldilocks' episode of low global inflation and 2-3 per cent economic growth is largely behind us.

Bond markets benefit

The bond markets benefit from the continued focus on downside growth risks, easing inflation and existing uncertainties in the stock markets' earnings potential. We expect bond yields of 10-year US Treasuries of 3.60-4.10 per cent on a three-month and 3.90-4.40 per cent on a 12 month horizon. Investors who are concerned about capital preservation and safety could focus on high-quality government bonds and corporate bonds. Avoid high-yield bonds, as default rates are expected to rise into 2009. In the longer term, the US government bond market is vulnerable due to massive increases in America's fiscal deficit as it shores up financial institutions and provides funds to remove illiquid and non-performing assets from the banks' balance sheets.

US dollar appreciation

The US dollar rally in July and August was the biggest since 2005. This trend reversal in the US dollar not only signals a turn in some fundamentals, like the improvement of the US trade deficit, but is also partly a reaction to the strong correction in commodity prices and economic growth differentials.

The US dollar is forecast to appreciate to 1.38 euros on a three-month horizon and higher on 12-month horizon on valuation aspects and a faster recovery of the US economy in the second of half 2009. At the same time, Euroland economic growth is likely to slow and the European Central Bank may start cutting rates. Crucial to our outlook is continued confidence in US capital markets and regulatory policy, and capital repatriation to the US.

A slight depreciation of the Japanese yen seems likely, and exchange rates of 105 yen per US$ and 110 yen per US$ are expected on a three-month and 12-month horizon.

Equity markets: Some downside risks

Equity markets have been under pressure from the adjustment of credit market excesses, as well as the weakness of the banking sector. Even more pronounced setbacks have been experienced by some emerging equity markets. But further setbacks cannot be ruled out due to continuing downward earnings revisions as the real economy weakens. Headwinds lie ahead for some corporations due to high commodity prices, wage increases in some developing countries and falling demand. Equity markets should be treated with caution, despite attractive valuations.

The recovery of the financial sector in the US and Euroland is crucial for a sustainable recovery of the global equity markets. Banks are conserving capital, and require more equity and debt financing. US policy response has been swift over the past weeks - liquidity injections, the rescue of Fannie and Freddie Mac, consolidation by banks and a proposed state bailout fund for mortgages.

This has reduced systemic and macro tail risks. Historical experience, however, points to a likely complex and time-consuming debt work-out period for banks, before lending expands and earnings recover steadily.

On a 12-month horizon, the growth outlook should have brightened and the financial crisis will run into its second anniversary. Most of the ongoing deleveraging and adjustment process might be closer to its end, and equity markets might start anticipating a recovery. On the downmarket moves, emerging market equities have fallen by more than those in the developed world due to risk aversion, while on the upside to recovery, we believe emerging market equities will be in a relatively strong position. Emerging equity markets have benefited from a structural rise in global competition, the emergence of new sales markets, higher corporate profitability and dynamic growth.

Alternative investments: Selection is key

Commodity markets have corrected sharply. The oil price has fallen about 30 per cent from its record high near US$150. Other commodities have seen sharper drops - for example, zinc and nickel. The correction is expected to continue into the fourth quarter of 2008, though to a lesser extent. As for the commodity sector, we retain our preference for soft commodities on a medium-term view. Agricultural products should continue to yield good prices due to sustained high demand (changing diets in Asia and ethanol production) and limited supply (weather-related supply shocks, declining global inventories). However, individual crops might show volatile price movements.

For oil, prices are likely to stay around current levels due to lower cyclical demand. We expect US$90 per barrel on a three-month horizon and US$100 on a 12-month horizon, as supply is constrained on a medium-term basis. On precious metals, the gold price is likely to be about US$800 on a three-month horizon and US$850 on a 12-month horizon. Gold has potential upside as a store of value, and may exceed our forecasts should the US dollar recovery be tempered.

The year 2008 has been eventful for hedge funds. So far, commodity trading advisers and macro strategies have done better, but long-short equity strategies face challenging times. Looking ahead, we expect macro, multi-strategy and distressed funds to provide strong investment opportunities. At a time where counterparty risks and short-selling rules might affect some hedge funds, manager selection and style allocation remain crucial for successful investment in hedge funds.

The writer is chief investment officer Asia, Deutsche Bank Private Wealth Management


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