Sunday, January 18, 2009

Two points of light in the gloom

THE economic outlook looks grim over the next two years, says Blackrock head of asset allocation and economics Richard Urwin. But there are opportunities in the credit space, for instance, as clients seek yields higher than cash.

And, Asia may yet see a recovery ahead of developed markets as monetary stimulus is likely to show benefits sooner. 'Easier monetary policies have the best chance of working probably in Asia where the financial system is under less pressure and the banking system is less leveraged. At some stage Asian equities could start to do better (than developed markets).'

Earlier, Blackrock vice-chairman Bob Doll issued his predictions for 2009, markedly more muted than his predictions for 2008 which had been off the mark. The deterioration in markets and economies since the Lehman Brothers' failure has taken most strategists and analysts by surprise.

Mr Urwin told journalists yesterday that the macro environment is 'very challenging' and while a recovery will ensue later this year, it will be 'pretty subdued'. 'This leads us to a world which by the end of the year begins to improve, but slowly, painfully and erratically. We're not going back to normal cyclical conditions for two years. But there are investment opportunities that beat putting money in the bank.'

One opportunity, he says, is in non-US government bonds and another is investment-grade corporate debt. Government bonds are expensive, he says, but interest rates cuts are expected to be significant even in emerging markets. Hence low government bond yields may not be unreasonable 'in an environment of zero interest rates, recession and subdued growth and with the emphasis on deflation risk, investors are not content to earn nothing in the bank'.
Treasuries will begin to sell off when conditions become 'more cyclically normal'. Ten year Treasuries are yielding around 2.3 per cent. 'We are some months from that, maybe not this year. When there are more signs of a sustainable upturn, bond yields will rise. Outside the US, there is scope for yields to fall further.'

Investment-grade credit spreads have tightened from 320 basis points to about 270 over the past few weeks. 'Credit spreads at this magnitude discount an incredibly high default rate...You are being offered an extraordinary opportunity to buy corporate credit as measured by the spreads.

'We're in an environment where people lost money last year. They will reach for yields.' He adds that while it is consensus opinion that investment grade credits are attractive, few have moved to invest. 'It's not a crowded trade.' Bonds, however, remain fairly illiquid with a substantial liquidity premium built into the spreads.

As for high yield or sub-investment- grade bonds, he believes it is not yet time to invest even though yields are at fairly high double digit levels. This is because default rates are expected to escalate. Equity markets, on the other hand, are expected to be weak on the back of earnings weakness. Earnings, he says, may 'collapse' by 30 to 50 per cent. Valuations, however, are already almost at historical lows. The Hong Kong market is at all-time lows; the US market values are at 1980 levels.

'Equities are as cheap as they have been for 20 to 30 years. But that does not tell us there will be an immediate strong rebound. What this tells us is the equity investor is expecting earnings to collapse. These are the valuations we get in a steep cyclical downturn. The good news is I think they are widely expected.'

He adds that markets may have hit bottom - with a '60 to 70 per cent degree of probability. 'It's feasible to revisit the lows but our best guess is we do not break them.' He expects equity markets to end 2009 higher than current levels. On alternative assets, he likes the global macro hedge fund strategy and gold. The latter is a hedge against two events, which he says are not in Blackrock's base case scenario. One is a collapse of the US dollar, and the second is that the financial system continues to struggle to a greater extent than expected.

To some extent, deflation, he says, is beneficial as it lowers costs for households. 'What we have to worry about is an environment where price cuts are more widespread, deep and sustained. That is a genuine deflationary environment.'

Meanwhile, Mr Doll, in his 2009 forecast, said 2009 is likely to see a 'slow but noticeable' return to risky assets over safe assets. An equity bottoming process began in October, he wrote. 'Bottoming processes typically take months to complete with re-tests of lows possible. However, increasingly attractive valuations coupled with high degrees of scepticism, supported by massive sideline cash, lead us to believe that equities will have a positive, albeit volatile, year.


Here are Blackrock vice-chairman Bob Doll's predictions for 2009:

The US economy faces its first nominal GDP decline in 50 years.

Global growth falls below 2 per cent for the first time since 1991.

Inflation falls close to zero in many developed countries, but widespread deflation is avoided.
The US Treasury curve ends 2009 higher and steeper than where it began.

Earnings fall by double digit percentage again in 2009, the first back-to-back drop since the 1930s.

High yield, municipal and investment grade bond spreads narrow in 2009.

US stocks record double digit percentage gain.

US stocks outperform European stocks, while emerging markets outperform developing ones.
Energy, healthcare and information technology outperforms utilities, financials and materials.
Stock market volatility remains elevated as periodic double digit percentage rallies and declines occur.

Oil and other commodities bottom and move higher by year-end as emerging market economies begin to recover.

The US federal budget deficit soars past US$1 trillion as the government continues to grow.

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