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RECOVERY AND INFLATION ARE 2010’S THEMES

GEORGE TCHETVERTAKOV
HEAD OF MARKET RESEARCH, ALPARI UK

IF 2008 was the year of the crisis, then the story of 2009 was recovery. Until March, this looked unlikely. Given the losses suffered by financial institutions during the financial meltdown, there were severe doubts whether the world’s banks and economies could bounce back.

But signs of recovery emerged, beginning with comments from banking executives confirming better trading conditions, followed by a return to profitability for US banks in the first quarter. This helped to create a floor for equities and consequently “green shoots” of recovery. Government support was a key factor.

Gradually, expectations of a recovery solidified and by the second quarter other sectors of the economy, such as telecoms and IT, were showing good results. This led to a broad recovery consensus. The effect on financial markets was a strong, steady rise in equity markets – especially in emerging markets, which were fertile ground for higher returns. Commodity markets rallied on the back of expectations for higher global demand, led by China and the US. Currencies reflected the confidence quicker than most other asset classes. Traditional safe havens were sold aggressively as sidelined investors reallocated portfolios into better yielding investments, such as emerging market equities, corporate and government bonds and commodities as an inflation hedge play. Higher yielding, cyclical commodity currencies such as the Aussie and Kiwi dollars have been the best FX performers during the recovery.

March was undoubtedly the turning point from a pricing perspective (see chart). Broad confidence was achieved only later in the year through monetary support in the form of quantitative easing QE, and direct help for key industries in the form of fiscal packages.

The supportive measures introduced in early 2009 are still ongoing. Japan recently announced $80bn more support. Other authorities have vowed to reign in supportive measures in the immediate future, for example Switzerland and the Eurozone.

The displaced timing of support introduction and in turn support withdrawal has been one of the key themes of 2009. The level of aid was unprecedented. The US and the UK put forward the largest amounts of funding as a proportion of their GDP and were also the first to adopt QE. So far it seems that this approach has failed to bring about inflationary effects.

However, in 2010 this could become a major factor. As economic growth gathers momentum it will induce an increase in the multiplier effect, increasing the likelihood that inflationary effects will surface quickly. This would be problematic because inflation can appear very quickly, whereas the unwinding of stimulus measures – which includes the sale of purchased assets – cannot take place without creating adverse price movements and sharply higher yields.

Higher yields on government debt are dangerous because although this can be a sign of a strong recovery, it also implies higher debt burdens for the issuer. In 2009, words like write-downs, deflation, QE and green shoots made the headlines. In 2010, they will be replaced by exit strategies, inflation, rate normalisation and bond yields. One thing is certain, though. Whatever comes next, the FX market will continue to be the best macro indicator of investment trends.