As I listened to the common market chatter a few months ago, it was very easy to get pessimistic about the outlook for the global economy and financial markets. Even today, financial bubbles, money printing, incapable governments and “gloom and doom” still seem to be the favorite discussion topics of many investors. I almost got depressed, which, in my role as investment manager, doesn’t happen very often. I agree, it’s very hard to leave out emotions completely when analyzing the investment world today, but, we try to be as unbiased as possible when we do our work and to stay focused on facts.
So where do we stand today? Is the recovery in financial markets just a “dead cat bounce” and is the mother of all crisis upon us? We do not think so and feel this is not the right time to get lost in pessimism and frustration. The chances of a global double dip recession have diminished dramatically in the past few months and the likelihood of such a dramatic drop back is now less than 10% in our view. There are, however, regions for which we tend to be more pessimistic, mainly the U.S., but in general I think the global economy will experience further normalization and could actually surprise to the upside in many markets.
From an economist’s point of view, a couple of things are of course worrisome, mainly the financial health of many governments. Greece, Spain and Portugal have been downgraded already and their credit spreads have increased significantly. Greece and to a lesser degree Spain, Portugal and Italy get pushed by the European Union to implement aggressive spending cuts to restore financial stability, but it’s difficult to keep up the pressure on those states since the largest members of the European Union, Germany and France, are also dealing with financial problems. It will take years for them to make all the necessary adjustments but I am glad to see that they are at least making an attempt to cut spending.
The situation in the U.S. is different but many states are dealing with huge problems as well, just look at California. It’s a situation that not even the “Terminator” can sort out anymore, and, as if the record deficit is not already enough, new and very large spending programs are about to be initiated. The recently passed jobs bill and the healthcare reform are interesting and very significant in this context. They both call for very large spending programs that attempt to create jobs and to improve health insurance coverage for everyone. From an economics point of view it is certainly encouraging that a lot of effort will go towards infrastructure spending, which tends to create real value for an economy. On the other hand, it is outright scary to see that the bill does not exactly define how the costs are financed. One of the major contributions should come from further measures aimed at generating higher tax income from so called offshore financial centers. The problem here is that nobody really knows how realistic these numbers are and what if, like many people think, these numbers are totally unrealistic and the actual generated returns are only a fraction of the budgeted amount? The other large looming spending program will be the new healthcare reform, which is from a moral point of view probably a good thing. The problem here is just that this reform will create a lot of new demand for services from an already inefficient industry, which tends to increase rather than decrease prices. The end result could be an outright explosion of healthcare costs, which eventually need to be paid for somehow. Adding more costs to the already way too big debt burden is a recipe for disaster.
There might be larger problems in some areas of the world, but the overall outlook at least for the next 12 months is improving and the risk for a global double dip recession has diminished significantly. It is actually surprising to see how quickly some regions have recovered; in particular countries which tend to be structurally sound and globally diversified are recovering much faster than others. We expect the current recovery to continue this year and probably well into 2011 and also expect financial markets to increasingly price in such a scenario. In our view, this will result in global equity and commodity prices rising further.
A common argument against this view is that markets are already valued expensively, but, this is a rather naïve view. A market valuation and analysis always needs to be done in the proper context, taking into consideration factors such as interest rate levels, operational and financial leverage, existing and expected inflation just to name a few. Under a more sophisticated view, global equity markets do not look expensive at all, let’s not forget that adjusted for currency movements, western equity markets have gone sideways for almost 10 years, yet, companies often have doubled and tripled their earnings during this time. Now, can we think for a second about alternatives to equity investments? Money market funds, fixed-income papers and government bonds hardly pay anything when denominated in a major currency. You don’t want to put your money into a black box hedge fund either, we all know too well what happens when you have no transparency and little control over such assets.