June 2009

In mid-May, much attention was given to the OECD's latest Composite Leading Indicators report, compiled with data from March 2009. Surprisingly, the report revealed a pause in the economic downturn in four economies: China, France, Italy and the UK.

Despite the OECD’s insistence that the positive signals suggested by the data were still weak, the financial markets interpreted them as evidence of “green shoots” emerging in the global economy that would hopefully herald an end to the recession.

On closer inspection, however, the good news in the OECD analysis is not that an upswing is in sight; it suggests only that the rate of economic decline may be diminishing. The market’s initial euphoric response to the report was subsequently tempered, albeit briefly, after the release of Euro-zone data showing a region-wide, quarter-on-quarter decline of 2.5% in GDP in the first three months of this year; the data also featured a hefty 3.8% contraction in Germany, the EU’s largest economy and foremost exporter, which was that country’s worst performance since it began to compile quarterly GDP statistics in 1970. This development was echoed in Asia, where the Japanese economy contracted by 4% during the period, its greatest quarterly decline since records began in 1955.

Nevertheless, the ongoing equity market rally is characterised by a capacity to quickly discount negative developments and by having sufficient intrinsic strength to shrug off poor data releases, while responding enthusiastically to positive ones. Equity markets tend to anticipate the end of a cycle, often correctly; the initial recovery phase from a trough is typically sentiment-driven, but this must ultimately be confirmed by earnings growth if it is to be sustained. As the current economic downturn is distinctly irregular, this growth may take longer to appear than hitherto, so, despite the current optimism, there is a clear risk of disappointment.

No-one can really be certain of exactly what stage we are at in the current business cycle, and whether it will be “V-shaped”, as many hope, or “W-shaped” i.e. an intermittent recovery followed by a renewed setback before a final upswing that will lift the economy out of recession. One month’s data does not represent a trend, and more information is required before any reasonable conclusions are drawn. In the meantime, the real comfort offered by the OECD’s report is its implication that the pace of economic decline is generally slowing. If this is indeed so, given the potential for severe damage that the ongoing recession was thought to harbour at its inception, investors should, for now, be grateful simply for that.