Market Outlook
ECONOMY: CAPITALISM IS DOWN BUT NOT OUT
In the midst of all the bad news and fear that surrounds us, it is important to consider that the pendulum often overshoots in both directions. Free markets have proven time and again that they are incredibly resilient and efficient. They remain the best means for fostering economic growth and productivity. Uncertainty will be with us for the foreseeable future, and sustainable growth is unlikely to re-emerge until confidence is restored, housing begins to stabilize, credit channels begin to function more normally and lending begins to re-accelerate. Nonetheless, we believe that policymakers, working alongside the private sector and investors, will ultimately succeed in stemming the slide.
GLOBAL ECONOMY IN DEEP RECESSION
The combination of a coordinated global contraction and intense risk aversion suggests that the depth and duration of this recession will be far worse than any we have experienced in generations. A seriously weak economy is apparent in the U.S. First-quarter growth for this year could be as bad as, or worse than, the 6.2% contraction in GDP in the fourth quarter of 2008. Unintended inventory accumulation will reverse in the first half of 2009 as companies cut production to bring inventories in line with plummeting demand.
Looking beyond the first quarter, the onset of a U.S. economic recovery is getting pushed further out. The most recent economic data suggests that we are now essentially looking at a 2010 story. However, keep in mind that we are approaching the spring of 2009 and markets are forward-looking. In the meantime, there is virtually no good news on the economy anywhere in the world. A late start to monetary easing in Europe, where the financial system is particularly vulnerable, and a combination of export dependence and strong currency appreciation in Japan are likely to prolong their recessions. We forecast a 2.7% contraction in U.S. GDP for 2009, with Canada experiencing a decline of 2.2%.
INFLATION FEARS HAVE MORPHED INTO FEARS OF DEFLATION
With capacity utilization falling globally, concerns about inflation in the market have essentially shifted to worries about deflation, which acts as a disincentive to consumption. A bout of serious deflation could be particularly damaging for an indebted economy since it raises the inflation-adjusted cost of servicing or repaying outstanding debt. Simply put, each dollar of unpaid debt becomes a bigger dollar. A bout of mild deflation is a real possibility, but should prove transitory. The Fed is responding to this concern by flooding the system with money, but the velocity of money has plummeted, as much of it is being hoarded by banks rather than working its way into lending. Our forecast for U.S. inflation falls to -1% from 0.5%, reflecting continued weakness in the global economy. We forecast Canadian CPI at 0.75%.
FED TAKING MULTIPLE STEPS TO ENSURE THAT THE CREDIT CRISIS EVENTUALLY PASSES
The Fed’s powers are not pinned to interest rates alone. Monetary-policy responses to the financial crisis have been innovative and aggressive. We would not be surprised to see a host of new programs added to the list before this crisis has passed into the history books. Since there are few constraints on how large the Fed’s balance sheet can become, the Fed is creating cash and using it to fund a multitude of new lending facilities to help ease stress in credit markets. As part of that effort, the Fed continues to move toward a new program to purchase long-term U.S. Treasuries. Other programs include a $600 billion program to purchase securities issued by government-linked mortgage finance companies, Fannie Mae and Freddie Mac.
LOW INTEREST RATES A FIXTURE
Short-term interest rates are almost certain to stay at rock-bottom levels. We forecast a U.S. fed funds rate of 0.25% one year from now. In Ottawa, the Bank of Canada will keep the overnight rate at 0.5%.
Government bond yields are set to trade in disequilibrium for a prolonged period, given the severe risk aversion dominating investor psychology, the lengthening time horizon to potential recovery in the economy, the small risk of a surprise uptick in inflation and expectations that the Fed will buy longer-dated Treasuries. We expect that situation to sustain itself, for now, even in the face of growing supply concerns. Yields need to stay low to stimulate a recovery. But when a whiff of normalization ultimately appears — watch out. As the crisis resolves itself, government-bond valuations will be increasingly vulnerable to a mean reversion in inflation and risk premiums. That should result in a sharp rise in our valuation bands and a reversion in yields toward equilibrium valuations.
STOCKS SINK, ONCE AGAIN
After a brief bear-market rally since the last release of Global Investment Outlook, stocks have fallen to fresh lows and returned to trading at the greatest discounts to fair value in more than a generation. No market has been left untouched by the collapse in valuations. Our models encourage our view that markets will ultimately value companies based on their through-the-cycle earnings power, not on trailing or forecast profits generated at the trough of a severe recession. As the crisis clears, stock prices will ultimately move to reflect normal earnings power.
ASSET MIX REMAINS TILTED TOWARD STOCKS
We recognize that the nature of events over the past 18 months and the challenges that still lie ahead for policymakers and investors suggest a bunker mentality in equity markets is logical. Nevertheless, we believe that a fix for the financial system will ultimately emerge. Some important pieces have already fallen into place. Ultimately, investors will turn their attention away from the fear and confusion that has gripped markets and toward the opportunities that exist. Stocks will eventually recover, and returns will be above average for a lengthy period as normal valuations are restored. The scale of the decline in equity markets since last summer, the resulting deeply depressed valuations and our belief that initiatives designed to right the financial system and force feed growth, will work, encourages us to maintain our overweight position in equity markets.
