Equity and credit markets have begun the second half of 2009 looking quite fatigued, which is not a good sign ahead of the Q2 earning season. Perhaps the fact that markets have come so far in such a short period of time has itself prompted a pause. An alternative explanation is that the summer lull is kicking in, with many investors taking the end of H1 2009 as an excuse to book profits and wait until activity picks up again post summer holidays. A more worrying and more likely explanation is that the massive improvement in market sentiment seen in H1 2009 is giving way to uncertainty.
Relief that there will be no collapse of the global financial system is not sufficient to keep the momentum in equity and credit markets going into the second half of the year. Until now there has been plenty of less negative news and use of the now worn phrase “green shoots”, but little information to judge the magnitude and speed of recovery going forward.
There are plenty of factors that will dampen recovery in the months ahead. Higher unemployment, massive wealth loss and increased savings will provide a clear downdraft to the global economy. Banks will be increasingly laden with bad loans due to credit card delinquencies, commercial real estate defaults and other sour loans and are unlikely to step up lending in a hurry. In addition, it is still unclear how quickly toxic debt will be removed from banks’ balance sheets, which will act as another impediment to recovery.
Risks outside the US remain significant. Although the outlook for China is improving it is unclear whether the momentum of growth in the country will continue once current stimulus measures are utilised. Much will also depend on whether China and other export economies can shift growth impetus from external demand to domestic demand.
Moreover, concerns about the dollar’s use as a reserve currency continue to intensify as various large reserve holders attempt to diversify away from the dollar. Although a dollar collapse is unlikely the risk that foreign investors reduce their exposure to US Treasuries remains a threat to the dollar. This could push up long term interest rates and in turn mortgage rates in the US.
The European economy is a particular riskto global recovery, with only a gradual recovery expected. In particular, the biggest Eurozone economy Germany is struggling in the wake of a collapse in exports and a lack of domestic demand. Moreover, banking sector issues remain unresolved especially as there has been little information on European bank stress tests. The relative strength of the euro and inability of some countries in the Eurozone to devalue their way out of the downturn will also dampen recovery prospects. These factors suggest that Europe will lag the recovery in other countries such as the US and UK where the policy response has arguably been more aggressive.
The jobs market will lag the recovery process but there are signs that things are becoming less severe. The pace of job losses in many countries is lessening. In the US for example, non farm payrolls report revealed that average monthly job losses in the second quarter of 2009 at 436k were much lower than the 691k average monthly job losses in the first quarter. The bad news however, is that unemployment rates continue to rise. In the US the unemployment rate is likely to head to around 10% from 9.5% currently and this will be echoed in Europe where the unemployment is at a 10-year high of 9.5% currently.
The bottom line is that the market rally may have been justified so far but there is little to carry the momentum forward. Equity valuations dropped to low levels in March but can be hardly considered cheap at present. The improvements in indicators of market stress have also reached dramatic levels and going forward there will be plenty of pitfalls in the months ahead.