I keep harping on during client
presentations that financial markets are more forward looking than any
economist, analyst, journalist, or any single piece of economic data.
My reason for labouring the point is that I keep reading confident
predictions that this rally in equity markets we are currently enjoying
will inevitably fizzle out.

The
reason most often quoted for such a forecast is that the world is still
a nasty place. The world economy is still mired in recession, and it is
by no means clear that problems in the US and global banking system
have been properly addressed.

Yep,
agree with all that. The major economies are still in recession, and
likely to stay there for much of this year. The downturns in the UK and
Japan in particular are as severe as any in living memory.

On
the financial system, I don’t believe we’re out of the woods yet
either. Not long ago, the results of the US Federal Reserve’s stress
tests on US bank balance sheets were released, which showed that the
worst offenders ‘only’ need to raise around $75 billion or so to
provide for the losses that are likely to emerge during a supposedly
‘adverse’ economic scenario. I agree totally with sceptics who believe
that those tests were nowhere near stressful enough, and that the
losses will end up being much larger than officials are prepared to
recognise.

What
about here in Australia? If we really believe that some better than
expected retail numbers, and the fact that we avoided two negative
quarters of GDP growth in a row means that we’ll be sweet, then frankly
we are utterly deluded. The private sector has been shedding jobs for
over a year, and business surveys tell us that more job losses are to
come. We’ve only started to see investment intentions being wound back,
and our exports haven’t yet responded to the collapse in our major
trading partners’ economic growth.

All
this sounds awful I know. So, the recovery in equity and credit markets
we have seen this year is obviously unsustainable: a bear market rally,
a false dawn, right?

Nope.
There will certainly be setbacks – times when markets take one or two
steps back after three or four steps forward. However, here are some
reasons why the recovery might be sustainable.

After
the failure of Lehman Brothers, the world financial markets and indeed
the world economy really were teetering on the edge of an abyss. The
financial system is the central nervous system of the world economy,
and that system had effectively shut down. In that environment, equity
markets truly nosedived for what looks to me like the last time for
this crisis. Since those desperate times in the final quarter of 2008,
conditions in world money and credit markets have improved
significantly, and the world took not just one, but many steps back
from that abyss. In short, the probability of a 1930s scenario unfolding has plummeted.

The
recovery in equity and credit markets has been followed by a clear turn
in a range of global leading economic indicators: in other words, those
numbers that tell us where we might be heading as opposed to where
we’ve been. The recovery in these indicators now looks well established.

I
believe that banks in the US and elsewhere will need to raise
significantly more capital than either they or monetary officials are
willing to acknowledge. However, better equity market conditions have
made capital raisings considerably easier for both financial and
non-financial companies.

Moreover,
even if these conditions were to take a turn for the worse, we now know
what the authorities’ instruction manual looks like. If a large US or
UK or European institution needs to raise more capital and cannot raise
that capital from private sources, public capital will be injected. 

As
one of the better brokers out there put it in a recent research report,
recoveries never look likely, yet they happen all the time. I think
this recovery is sustainable.

That
said, none of us should do our planning on the basis that we get a
quick return to the kind of spectacular returns we enjoyed over the
five years or so before the crisis.

Brian Parker is investment strategist for MLC Investment Management

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