Bouncing back?

- BT Financial Group


In early 2009, global share markets kept failing, driven by forced selling by investors and institutions with high levels of debt, high levels of gearing and by a lack of confidence that market conditions would improve. In other circumstances many of the investors who were forced into selling might have been able to stick to their long-term view. Unfortunately, the combination of high levels of debt and falling markets but them with very few options. When investors are forced into selling, it’s usually liquid assets (by definition, any asset that is easily converted into cash) that are the first to go. That often means listed shares, and that’s one of the reasons we saw share markets continue to fall.

Before the bounce

Fortunately, as  BT Chief Economist, Chris Caton keeps saying, ‘Bear Markets don’t last forever’. Early in 2009, the Investment Solutions team decided conditions were right to start buying shares rather than selling thern. There were a number of key factors that drove this decision.

We knew that much of the downward pressure on markets was a result of uncertainty about the financial sector. In March 2009, the US Treasury Secretary Timothy Geithner, announced what markets thought was a credible plan to buy ‘bad assets’ off US banks. This move helped to recapitalise banks, freeing them up to resume traditional banking activity.It became obvious to us that investment markets had fallen too far. Good quality shares looked extremely undervalued.

In our view all the potential negative news was already built into market prices. This made the market extremely responsive to any good news. Corporate earnings numbers that did come in were bad, but not as bad as expected (which is no surprise when you consider that markets had priced in a depression-like scenario). Many investors had ignored the resolve and resourcefulness of global policymakers to implement initiatives that would revive global growth and eliminate ‘uncertainty risks’ priced into key financial assets.

The bounce back  winners and (some) losers

It now looks like financial markets reached a trough on 9 March, 2009. And, just as the length and severity of the current bear market caught many experts by surprise, so has the speed and extent of the recent bounce. Since 9 March, the US S&P500 index is up around 36% and Australian markets are up around 30%. Meanwhile oil prices are up over 100% from their lows. Many investment institutions that had a highly defensive position have been reallocating capital into growth assets and this has fuelled the strength of the rally. As is often the case in investment markets, last year’s best performing asset class is now the one to suffer. Government bonds were the standout asset class of 2008 but their performance has dipped dramatically. Returns from corporate bonds, amongst the big losers In 2008, have now bounced sharply upwards. BT investors benefited from this switch as our fund managers had raised their allocation to corporate bonds.

Where are we now?

Global share markets are now back at somewhere near fair value and the BT view is that we are unlikely to retreat to the lows reached in March. Markets may rise on good company earnings news or on economic strength but continue sideways when the positive data dries up. Volatility will remain a feature.

Commodities

In our view, the China story is still the story. Spending on roads, rail, and ports, and especially on improving access to China’s interior has gained momentum and will continue to remain so for many years to come. Many emerging econornies are also pursuing similar strategies. According to the World Bank, China is now at the most commodity-intensive phase of its growth. That’s driving all sorts of geopolitical decisions, including investments in Australian and African resource companies and cash for energy swaps with countries like Russia and Kazakhstan.

We believe Chinese demand and other emerging market demand will underpin continued strength in global commodity markets and we want to give our investors an opportunity to gain exposure to this asset class. However, commodities are volatile and can add excessive risk to a portfolio. Investing in commodity stocks also has its downsides. In the aftermath of the global financial crisis, many commodity companies will struggle to fund big new capital expenditure. Others are carrying too much debt or will find it difficult and expensive to rehire staff cut during the recent downturn.

That’s why we use a specialist commodities future fund to give BT investors direct access to commodities including oil, gas, gold, base metals and agricultural commodities. This is a highly effective way to deliver cost-efficient, risk-managed exposure to the return potential of commodities.

International shares - a focus on emerging markets

Emerging markets have already done very well, with the FTSE Emerging Markets index up around 60% between the beginning of March and the beginning of June.

Our view is that this outperformance will continue, but only in some emerging markets. We’re being selective and instructing our international managers to opportunistically move up to 20% of their portfolio into emerging markets.

According to RGE Monitors, India and China are two of the very few countries likely to grow at 5% or more this year. They will be mainstays of global growth in the future and this will benefit the rest of Asia, not including Japan. We’re moving money into those countries and also into Brazil, Russia and some Latin American economies.

The medium term outlook

In our view there could be some pullback from the market’s current levels, but those pullbacks will be muted as people start to buy good quality shares at low prices. We’re likely to see higher highs and higher lows.
The next major boost may come as the huge wave of government economic stimulus starts to take effect. Cash rates around the world are now near all time lows (Australia’s official cash rate, for example, is down to 3% from 7.25% in September). Those two forces plus the level of fiscal stimulus should eventually overpower lingering negative sentiment and drive share markets in 2010.

In 2011 governments may start to take some of that stimulus off the table - cash and bond rates will probably move higher and government spending will tighten. Those conditions are normally not so good for shares. However, given what global economies have been through over the past two years Finance Ministers and central bankers won’t want to move too soon.

Patrick Farrell, Head of Investment Solutions, BT Financial Group