October 2009

Increasing signs of economic vitality around the world continue to support claims that the financial crisis-engendered recession is coming to an end. At least a growing list of political and economic luminaries believes this to be the case, although, in statements from the central bank elite, the word "probably" is a notable feature.

Recent data suggest that the note of caution expressed by the monetary authorities is well founded. Certainly, much of the world economy is stabilising, but this is not the case across the board, and the ongoing stabilisation cannot be said to be broad-based. Many economic areas, notably the US housing market, are still struggling, albeit less desperately than a few months ago, while unemployment is set to rise further, which will undermine the potential of any recovery.

Whether or not the recession is over, investors should not confuse the end of a downturn with the beginning of a sustainable economic recovery. The two are not synonymous (although much of the financial community continues to foster the illusion that they are). Already now, growth projections are being raised considerably. But, as earlier forecasts proved to be too bleak in hindsight, economists and policymakers may simply be playing catch-up; given their failure to anticipate the severity of the global economic downturn, the predictive abilities of the pundits are not exactly reliable.

Sea of liquidity

The gains in financial markets latterly have arguably been driven as much by the huge amount of available liquidity as by improving economic prospects. This can be seen in the relative outperformance of “risky” assets (equities, corporate bonds and emerging market debt), whose attractions, in the current environment of unprecedentedly low interest rates, far exceed the paltry returns offered by cash and government bonds. However, central banks, fearing the long-term inflationary consequences of maintaining excessive liquidity in the system, will eventually become less accommodative. When this happens, the rally in risky assets will find its lifeblood drained, and investors must hope that such moves will be in tandem with corresponding economic improvement if further investment gains are to be had.

Too much liquidity can inflate asset valuations to unsustainable levels. Many analysts now contend that, following the advance that began in March, markets are fully valued; they see the rally in risky assets running out of steam and predict a lengthy technical correction that they say is long overdue. Nevertheless, even if such a correction materialises, while liquidity remains abundant, and until the central banks begin to implement their “exit strategies”, there will be opportunities for investors to exploit.