Market Commentary - 2012 - Quarter 2 July 2012

Market Commentary - 2012 - Quarter 2

The second quarter of the year has been very different from the first, with negative returns repeating the patterns seen in 2011.

The quarter started more negatively following the first quarter rally, and has maintained this general negativity through to July. The areas of concern are well documented and have been discussed by us in previous quarters. The problems of the Eurozone are well known, as is the slowing of growth in China and the weakening of certain US data. Elsewhere some of the geopolitical risk has eased in places such as Iran, although Syria is causing global concern even for backers like Russia and China. Global markets, which we will discuss in more detail later, have finished the quarter 2-3% down but have been 8-10 down at certain points, before the most recent rallies.

With the same continuing themes creating the roller coaster market environment, it makes sense to consider the crisis from a slightly longer term perspective. This will hopefully shed some light on why the global economy is finding it so difficult to move out of this phase.

In a recent speech the Bank of England Governor Mervyn King commented that ‘…as far as he can see the global economy is still only half way through the financial crisis which commenced in 2008’. This is clearly disappointing, but followers of economists Carmen Reinhart and Ken Rogoff will find this less surprising. In their study of financial crisis ‘This Time It’s Different’ they observed that in the aftermath of a systemic banking crisis the resulting shock to the global economy made economic recovery slow and volatile. Their research showed that in such an environment looking at standard macro economic models to forecast growth and recovery is of limited use and that downturns caused by severe financial crises have always been protracted affairs. They provide evidence that in previous financial crises declines in real house prices typically stretched out over six years. In addition, unemployment generally rises significantly and remains at elevated levels for a number of years, this being described as a ‘jobless recovery’. The nearest comparison for many observers is the great depression from 1929 after which most countries took over ten years to reach the same level of per-capita output they enjoyed pre-crisis.

In this environment the strain on government finances increases rapidly as benefit systems kick in and tax revenues reduce, all of which continues for longer if there is no pick up in the employment rate. Governments this time around learnt from the mistakes of the 1920’s and ‘30’s and quickly addressed some of the issues with both fiscal injections and monetary easing which averted disaster but also increased debt on sovereign balance sheets. Sovereign default, debt restructuring and / or near default, which has only been avoided by international bail out packages, have in the post war period only been associated with financial crises in emerging markets. However, the distortions in borrowing rates caused by the Euro, together with the rapid deterioration in peripheral European countries’ balance sheets, has resulted in western economies replacing emerging ones as the primary sufferers of sovereign stress.

Other downturns in recent times have either been country specific or, at worst, regional so the stress placed on the wider global financial system this time has resulted in only modest economic rebounds. As banks have been forced to repair balance sheets and make debt write offs, new lending has been constrained. So, despite the efforts of the Central Banks, rapid expansions in money supply have yet to occur in most affected countries. The global nature of the downturn has meant that it has been very difficult for any country to export its way out of the problems into recovery.

Ultimately the countries worst affected by the crisis shared many common domestic macroeconomic fundamentals - housing bubbles; capital inflow bonanzas; increased private and/or public borrowing – and the cumulative effect of a long-running banking crisis was demonstrated by Mervyn King’s remarks on the likely longevity of current problems.

So what does this tell us about the immediate future? In the current environment we should be prepared to face periods of sub-trend growth in particular in the west. This is a reflection of the slow changes in key areas such as inter-bank lending and employment rates, and is not easily resolved.

Despite this less positive background we believe that investors should not ignore risk assets over the longer term. There are strong and innovative companies that can continue to deliver growth (and dividends), from which investors can benefit when the global economy eventually picks up.

Market commentary provided by Rayner Spencer Mills – Quarter 2 2012

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Independent Financial Advisors