Recovery could see more volatility

10 August 2009

Julian Chillingworth, Chief investment officer, Rathbone Unit Trust Management

The recent positive economic news suggests the beginning of the end for the recession. However, we may not have reached safety just yet as the economy could be at risk of another downturn.

Once consensus chants that it can only get better, it is time to rethink. The recent impressive run in the FTSE suggests the beginning of the end for the recession, and the start of a new trading range for major markets.

However, at best, markets now look overbought, and potentially vulnerable to a pull-back. We may no longer be facing an abyss, but there is little reason to declare we have reached safety.

Economic news has provided more cause for optimism. Most significantly, American GDP came in at 0.5%. This was better than the 1.5% contraction forecast, but slightly clouded by a big revision to first quarter figures, which showed a 6.4% decline. President Obama has (rightly) attempted to manage expectations of a smooth recovery, but that expectation of growth in the third quarter will probably be enough to propel markets through the summer.

Are investors right to be so bullish? There is some optimism but we have our reservations.

Since the start of the credit crisis, markets have been driven less by fundamentals and more by sentiment – this phase is no exception. Investors are finally having their thirst for signs of life quenched by better than expected earnings, and strong growth, to a lesser extent, from emerging markets. Yes, the American economy might be bottoming out, but corporate America is not as healthy as the latest numbers might suggest. Essentially, positive earnings have driven numbers, and this is more reflective of short-term cost-cutting and, to some degree, restocking.

The give-away is the revenue number, for which there have been few positive surprises to excite the market. Why is this number so important? Well, it implies weak underlying demand from the American consumer – an implication that received further credence from lower inflation and consumer confidence figures. The Conference Board Consumer Confidence index dropped to 47 in July, having hit 49 in June and a high of 55 in May. The Michigan University consumer confidence index also dropped, from 71 in June, to 66 in July. On closer inspection of the GDP figures, tepid demand also resulted in a tiny 0.2% pickup in the GDP deflator, an inflation gauge.

Rather predictably, until creases in the housing and labour markets are ironed out, there is little chance of consumer behaviour returning to its “norm”, assuming it ever does.

Indeed, it is likely that the consumer will act in a more secular than cyclical fashion – in other words, not in line with the economy – and this has implications for us all. At the time of writing, Treasuries have rallied again after being overshadowed by risk trades in recent weeks, suggesting that inflation is not a threat, yet.

Britain has its own problems – the economy could still suffer a secondary downturn, driven by rising taxation and cuts in public expenditure. There is a major adjustment taking place, and one where livelihoods and lifestyles will be compromised for years, as the deleveraging process filters through the system. Many companies continue to struggle under the weight of weak demand and refinancing problems, as the recent meeting between the major banks and the Treasury serves to testify.

Technically speaking, western markets paint a much more bullish picture. Looking specifically at Britain and the FTSE 100, the market has broken above its 200-day moving average – a commonly used measure of the long-term trend – and is showing signs of another upward leg. Adding to the positive weight, a clear “inverse head and shoulders pattern” – which roughly translates into peaks and troughs – can be seen in the price action. Technical analysts say this can foreshadow a forceful move higher. In this instance, some predict the market reaching (an unlikely) 5,800. Other analysts argue there is formidable resistance in the area of 4,600 to 4,800 (the level of the FTSE 100 in September, 2008), and the market may oscillate between these levels. Adding to this negative weight is the fact that the market fell on rising volume at the beginning of this year and has since risen on consistently falling volume. The current run has been on low volumes.

There is a danger that strong gains will blind investors from asking key questions about the virility of G7 economies. Economic news is mixed at best – the key point is that painful, fundamental imbalances remain. There remains also immense pressure on companies and individuals to reschedule debt and mend overleveraged balance sheets.

As this reality dawns, markets should develop a bit more of a range. Historically, September and October see markets rein themselves in – moves in these months, therefore, will be significant. We see some froth being taken from top, and will be wary should markets continue onwards and upwards, regardless. Credit spreads are continuing to narrow. This is normally a good sign. But, with economies still recovering, news is likely to be mixed, perhaps suggesting more market volatility ahead as the recovery continues.