Is liquidity enough? By Chris Tracey, investment director The MSCI World Index, in US dollar t...
Is liquidity enough?
By Chris Tracey, investment director
The MSCI World Index, in US dollar terms, rose by just under 2.5% in October, but more remarkable has been the near 11% recovery of the index since its low on 21 September. The major reason for the recovery has been the further substantial fall in interest rates across the curve in the US, with the Federal Reserve cutting short rates by 50bps and 10 year Treasury yields falling by 36bps to 4.25 %, a level not seen since the 1960's. The fact that IT hardware was by far the best performing global sector over the month, rising by some 19% despite no sign of any recovery in tech demand, does suggest that the rally has been primarily liquidity driven. But, while buyers of equities are encouraged by the abundant liquidity and low interest rates clearly holders of government bonds are not at all convinced that all the fiscal and monetary easing is going to produce a 'V' shaped economic recovery with the associated risk of a rise in inflation. Nor, perhaps, are holders of corporate bonds, where the yield spread over US Treasuries of the lower quality investment grade bonds are at near record levels.
If the corporate bond market is expecting significant credit downgrades and non investment grade levels of defaults at least as bad as in 1991, it is perhaps surprising that equity markets have recovered as well as they have unless corporate bonds have simply got it wrong. If this is the case the latter are seriously undervalued. The crucial issue for global equity markets now is how the US consumer is going to behave, as that will determine the length and depth of the US recession. Behind the behaviour of the US consumer lies the relatively low level of savings and high level of borrowings, a hangover from the high confidence brought about by the full employment, rising real incomes and rising wealth of the latter 1990's boom. That virtuous circle is already reversing with unemployment estimated to have risen to 5.2% in September (it was 4.5% in July) and a savings rate that had risen from 1% in June to 4.5% in September. In both cases the equivalent peaks during the early 1990's recession was 8%.
Whether something close to these numbers is reached again is anybody's guess as is, in our view, the question of the timing and speed of any economic recovery. If it is of any help, the betting is that the 'official' start to the US recession will have been last June, as determined by the National Bureau of Economic Research, which has estimated that the average recession since the second world war has averaged 11 months. Our view remains that equity valuations generally are not yet at sufficiently depressed levels to overcome the lack of economic visibility so that we are not aggressive buyers, but we recognise that liquidity driven rallies can be very powerful. For balanced mandates, however, we are actively moving from government bonds to corporates.
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