Hope emerges despite slow growth

22 February 2010 | By Sunil Krishnan

Sunil Krishnan is a director and financial markets economist in the BlackRock multi-asset client solutions group


Investors’ focus is firmly on the sustainability of an American economic recovery. This relies on two factors, both of which will be watched by the Federal Reserve. The first is whether unemployment can peak, and there is enough reason to believe that a phase of positive job growth is on the way in the first quarter. The other factor is whether a normal pattern of credit creation can resume, with banks lending to smaller businesses–a key ingredient of sustainable growth.

Only if these factors show signs of improvement will central banks start to consider normalising policy. But when this happens, and how well investor sentiment can withstand the change in policy stance, will be another key talking point in 2010.

”Even dramatic fiscal tightening is unlikely to bring western debt burdens to stability until the middle of the decade”

Many investors are sceptical about whether the patient could withstand being taken off life support, and so the change of central bank mind-set is a potential source of volatility in markets.

But the recovery has solid foundations, and this kind of a setback would be a buying opportunity. There may be longer-lasting consequences in other areas, such as the currency markets, where dollar weakness could start to reverse if the American recovery is healthy enough to allow an exit strategy, and this is one of the surprises we expect to see at some point this year. (article continues below)

Investors often start to shift nervously in their seats when they become aware that everyone around them shares an investment view. At present, the most consensus view is that emerging markets remain attractive investments. We share this view given their relatively easy ride through the financial crisis. But that will not stop investors responding swiftly to any signs that optimism towards emerging markets is misplaced.

 

Various emerging markets have seen rapid currency appreciation as a result of international capital inflows, and attempting to cool down these flows without stalling the capital markets is a challenge for countries such as Brazil and India. This balancing act will be closely watched. But perhaps the biggest driver of emerging market sentiment will be how China manages to rein in the aggressive credit expansion of 2009. Property and food prices are always a concern for China’s policymakers, and it seems likely that at some stage this year the authorities will have to choose between ­controlling these prices and continuing to support economic growth.

The rise in deposit reserve requirements for Chinese banks has captured plenty of attention–many investors are wondering whether it is a sign of things to come. We expect that the reality of western economic weakness will keep policy tilted towards supporting domestic demand, and therefore will continue to support asset markets. But it is clear that investors will be quick to seize on any signs of early tightening.

It may be a surprise to see that the state of government finances is not higher up the list of what to watch out for. If investors were polled for their personal concerns, perhaps even a majority would highlight the unprecedented worldwide expansion in national debt levels likely over the next couple of years.

However, the long-term nature of this problem is part of the reason why 2010 may not be a year where this story develops significantly. Even the most dramatic fiscal tightening programmes are unlikely to bring western debt burdens to stability until the middle of the decade, and therefore 2010 is too early to see much improvement.

 

We can expect to see development of government plans for longer-term consolidation–especially once elections in America and Britain have passed–and the changing market perception of individual countries’ prospects. Greece’s situation remains precarious, and may be a further source of volatility in 2010, but there is a decent chance of speculative pressures coming to bear on at least a handful of other countries through the year, with Europe still a key focus.

These themes are likely to be the key determinants of investment returns in 2010. We expect the strength of the economic recovery to be underlined by a peak in western unemployment during the first half of 2010, and a return to bank lending growth in the second half. This should continue to support profits, drive further flows from cash to equities, and keep moderate upward pressure on bond yields.

Central banks will start to manage expectations for the exit strategy, but will not be in any hurry–there is every chance that at least one of the major economies will not see any rate rises in 2010.

The emerging markets will continue to enjoy a robust recovery even as policymakers try to keep the situation under control, potentially creating fresh challenges.

And government finances will be improved by the economic recovery, but will remain a source of volatility and a drag on western growth through this and subsequent years.