Second Leg Global Recovery (Sept 2009 Onwards) ...

Transition From One With China As Sole Driver To A More Balanced US/China Model.

Looking back at the first quarter of 2009, many investors, fretting about the woeful state of the global economy, failed to focus on the things that matter - valuation and the rapid acceleration of global policy momentum. As it turned out, the combination of these factors created the backdrop for the sharp rally in global equities over the past six months (March – Aug 2009).

Looking forward now (Sept 2009) from the heights that global equity prices have achieved, it is understandable that investors are getting increasingly wary. Admittedly, the valuation case has weakened with the rallies to date (Sept 2009). But global policy effectiveness has not waned. Rather, it has begun to shift from the Chinese-led successes of the first half of 2009 to a broader, global story, with US policy achievements, in particular, emerging recently.

This leaves the prospect for another leg in the global rally in equities that began in March 2009.

Continued momentum in US economic and earnings data in coming weeks (Sept 2009 & Beyond), underpinned by US policy momentum of the second quarter 2009, is expected to drive this leg of the rally. Year-to-date (Sept 2009), economic recovery momentum has been key to identifying relative outperformers globally. With emerging markets recovering from the 'Great Recession' more quickly than developed markets, economic momentum reflected in data releases has been a focus of market attention in the current rally (Sept 2009). Recall, early in the year (2009), news of the US and Chinese economic policy changes that helped set the stage for a bottoming in global markets.

With Chinese stimulus coming sooner and more aggressively, unsurprisingly, the MSCI China rose 35 per cent in the first half of 2009, compared with a meagre 5 per cent for MSCI World.With Chinese policy now (Sept 2009) stabilising, as Beijing tries to contain rapid year-to-date (Sept 2009) loan growth, US growth momentum is beginning to benefit from Washington's stimulus efforts of the late-first quarter of 2009. Their effectiveness was most recently seen in the July 2009 expansion of the Institute of Supply Management's New Orders Index, which historically has provided a three to six-month lead to turns in the US economy. Indeed, the most recent reading suggests that investors' concerns about job growth in the United States may begin to be addressed in coming months (Sept 2009 & Beyond)), providing further economic support to the earnings drivers that may emerge come October 2008.

Looking a bit further ahead, the US third-quarter 2009 earnings season likewise looks set to provide support to the market in coming weeks (Sept 2009 & Beyond). Indeed, during the rally since March 2009, the US earnings season - the first six weeks of each quarter - was a key driver for market performance. Recall, as the first-quarter 2009 earnings season got under way in April 2009, world equities, represented by MSCI World, rallied 18 per cent before stalling in mid-May 2009 as the earnings season came to a close. Similarly, as the second-quarter 2009 earnings season got under way in July 2009, world equities rallied another 12 per cent up to mid-August 2009, as the season came to a close again. In total, on a compounded basis, the earnings-season rallies accounted for almost two-thirds of the 52 per cent rise in global equities up to Aug 21 2009.

With another earnings season quickly coming upon us in October 2009, upward revisions to earnings expectations could continue into the northern autumn 2009, potentially providing a catalyst for the next leg of the rally we have seen since March 2009.

The resumption of US economic growth momentum and positive prospects for US earnings surprises in the third quarter 2009 suggest the global economic recovery is starting to transition from one with China as the sole driver to a more balanced US-China model. Indeed, since mid-year 2009, this transition in policy and data has resulted in US equities outperforming their Chinese counterparts, with MSCI US rising 11.5 per cent up to Aug 21 2009, exceeding the 5.7 per cent increase in MSCI China over the same period.

Therefore given that valuations are no longer cheap, expected news flow leads us to believe that caution will not be rewarded by the markets in the coming months (Sept 2009 & Beyond). Rather, investors are encourage to manage their risk by managing their exposure within global equities. Expecting that Asian equities, even after a near-50 per cent rally year-to-date (Sept 2009), as indicated by MSCI Asia ex-Japan, may participate in this next leg. However, unlike the first half of 2009, where they trumped the flattish 5 per cent performance of global equities, do not believe that they will necessarily lead regional performances as they did in the first semester 2009.

Rather, investors who ignored US equities early in the year (2009) may wish to reconsider opportunities provided by this market. However, they should keep in mind that while recovery looks entrenched, the US recovery is expected to come in sub-trend, with GDP growth in the recovery phase falling short of previous cycle peaks. With this in mind, investors may seek to focus on opportunities that continue to under-price even the modest economic recovery expecting.

Despite our optimism through to year-end (2009), we must admit that the global recovery story must be strengthened further to sustain the rally into the new year (2010). China, already grappling with rapid loan growth, must moderate its aggressive easing policy of early-2009 and structurally, continue to build its domestic consumer base. As for the US, it needs to transition its economy from a stimulus-led recovery back to a private sector-driven demand story.

On balance, though, while there are certainly concerns on the horizon, news flow over the coming months (Sept 2009 & Beyond) is expected to show not only recovery but, in the case of the US, accelerating recovery that investors have been hoping for, leaving the balance of risk and reward through year-end (2009) still pointed in favour of the reward camp, and creating an opportunity for investors to broaden out their focus from first-half leader (1H2009) emerging markets to include opportunities presented by US markets (2H2009) as well.

State Of Global Economy …

As the global economy returns to the path of a synchronised recovery, thanks to the synchronised massive spending of governments worldwide, manufacturers around the world are also gaining confidence to ramp up production and inventories.

The global Purchasing Managers Index (PMI) has now (Sept 2009) entered the positive territory for the first time since May 2008. The index at 53.1 last month (Aug 2009), rising from 50 in July 2009, provides an early indication that the global manufacturing sector is experiencing recovery in the demand for their products. Such trend will certainly add strength to the economic recovery process.

In the United States, for instance, the PMI for the manufacturing sector, as measured by the Institute for Supply Management, recorded the first expansion in August 2009 with a reading of 52.9, after 19 months of contraction. Any reading above 50 for the index signals an expansion.

As for the European manufacturing sector, the easing contraction has added evidence that the region is emerging from recession. The recent survey of purchasing managers produced an index reading of 48.2 for the euro-area manufacturing sector in August, compared with 46.3 in July 2009. Although any reading below indicates contraction, the rise in the European PMI last month (Aug 2009) was the highest in 14 months.

China is still charging ahead, with its manufacturing sector staying above the 50-mark for the sixth consecutive month. China’s PMI rose at the fastest pace in 16 months in August 2009, with a reading of 54 compared with 53.3 in July.

Similarly, Singapore’s PMI also stayed above the 50-mark for the sixth consecutive month in August 2009, with a reading of 54.4 compared with 51.5 in the previous month.

For most of the economies in Asia, what’s critical in boosting their manufacturing sector is demand from major advanced economies such as the United States and Europe.

This is indicated by the recovery in the import order from the advanced economies from minus 5.6% quarter-on-quarter (q-o-q) in the three months to March 2009 to a growth of 2.9% q-o-q in the April-June 2009 period.

Specifically, the recovery in the imports of the United States from a decline of 6.7% q-o-q in the first quarter 2009 to a growth of 3.5% q-o-q in the second quarter helped lift the exports and industrial production of Asia.

In Singapore, for instance, the industrial production in July 2009 rose 12.4% year-on-year (y-o-y), compared with a slump of 9% y-o-y in the preceding month.

State Of The US Economy …

The Budding Recovery Has Staying Power: Recent business austerity is boosting profits and the need to expand, and rising global growth is lifting exports, all while massive policy efforts continue to

The worst U.S. recession since the 1930s appears to be over. The best sign: Real gross domestic product, the most comprehensive gauge of the economy's ups and downs, almost certainly hit bottom in the second quarter 2009. Monthly data so far suggest a surprisingly strong advance this quarter (3Q2009) with enough momentum to keep the upturn going in the fourth quarter 2009. Still, many investors are skeptical. The improving outlook has succeeded only in setting off a hot debate:

Is the recovery sustainable, or just a temporary bounce fueled by a few one-shot government programs?

The debate will not be settled anytime soon, but several underlying forces make a strong case that the upturn is durable. Already, spending by consumers and businesses, homebuilding, and manufacturing activity have begun the third quarter 2009 with much more oomph than expected, and many economists think annualized GDP growth in the 3%-4% range this quarter (3Q2009) is a real possibility.

The key force at work is the sheer volume of fiscal and monetary policy. Its support of demand this year (2009) and next dwarfs any such effort in the downturns since World War II. To date (Sept 2009), most of the fiscal stimulus has been tax-related, along with other income support. However, much of the stimulus from infrastructure spending and other government outlays is only now (Sept 2009) working its way into the economy. For example, since January 2009 the growth of public construction spending through July 2009 has accelerated to an 18.9% annual rate.

Plus, the Federal Reserve's support of the credit markets will continue to strengthen financial conditions, so crucial to growth, well into 2010. Housing will benefit greatly. Already, the housing component of GDP is set to add to growth this quarter (3Q2009) for the first time in 3 1/2 years.

Plus, with home prices bottoming out, prospects for mortgage-backed securities will improve, helping to further shore up housing while stanching the bleeding on bank balance sheets.

Prospects for business spending are also looking brighter, especially given the surprisingly strong performance of profits, which drive the expansion of outlays and hiring. In the second quarter 2009, profits of nonfinancial corporations, based on the Commerce Dept.'s accounting, rose at a 19.3% annual rate from the first quarter 2009—an especially solid performance for a quarter with falling GDP.

Profit margins also grew last quarter (2Q2009), a testament to the benefits of corporate cost-cutting and productivity gains. Nonfinancial companies are emerging from this recession with margins much higher than at the end of the last recession. With revenues set to pick up in the second half 2009, further gains in profits are a sure bet.

Of course, consumers will be essential to a lasting recovery, and their help will require stronger labor markets. The plus here is that businesses have been extremely conservative in their spending and hiring, which puts them in a good position to gear up quickly as a recovery takes hold. Many are doing so, as the recent easing in job losses suggests. In fact, income growth, the key to any sustained increase in consumer spending, is already getting support from wages and salaries, which rose slightly in July 2009 for the first month in almost a year.

Finally, the upturn is global, with Asia, the Americas, and Europe all set to grow simultaneously. A synchronized recovery will boost the volume of world trade, especially to the benefit of U.S. exporters. Trade typically has been a drag on U.S. growth early in a recovery, as demand picks up in advance of other economies, boosting imports and widening the trade deficit. This time the trade gap is not likely to widen as rapidly, eliminating a potentially large hindrance to growth.
In the past, steep recessions have been followed by robust recoveries as was the case in the 1970s and 1980s.

The current (March – Aug 2009) upturn seems to be starting out that way as businesses restock their exceptionally low inventories. But even if it doesn't maintain its initial burst, the strengthening supports under demand in all major sectors suggest this recovery has legs.