Read PineBridge Investments - U.S. Market Watch October 19, 2009 text version

AIG INvestmeNts

U.S. Market Watch

OctObEr 19, 2009 | Markus Schomer, Managing Director, Global Economic Strategist


I recently attended a conference organized by the National Association of Business Economists (NABE) in St. Louis, Missouri. During a session presenting the association's outlook for the global economy, I was stunned to hear the presenter describe the current backdrop of strong economic recovery coupled with low inflation as "Goldilocks;" in other words, a fairy-talelike environment of prosperity. My first thought was, haven't we learned anything in the past 18 months? Didn't we realize that below the apparent calm of a "Goldilocks" veneer the seeds of an impending financial crisis were sprouting? Yes, the recovery is now on everybody's radar screen. We have been writing

since March about the potential of a very strong initial recovery, following a severe contraction around the turn of the year. This is now very much the consensus, and the rally in financial markets shows that investors are embracing this view, as well.

U.S. equity markets continued their strong performance through most of October and are up more than 20% so far for 2009, making up more than half of last year's 39% drop. The Dow broke through the 10,000 level in mid October, generating euphoric headlines. However, since March 1999, the index has crossed the 10,000 mark a stunning 44 times and adjusted for inflation, the Dow Jones really needs to get to 13,000 to equal the same value today.

In the U.S. Fixed Income markets, credit spreads continued to narrow led by emerging markets, which generated positive performance for the eighth straight month. Treasury yields have given back most of the surprising gains from September, but continued to trade below 3.50%. Finally, the dollar slide continued though most of October, with the Australian and Canadian dollar the main beneficiaries among the major currencies.

Economy & Policy

My schedule has been quite busy in the past few weeks and included a number of client visits in Ohio, where we presented our U.S. discussion for 2010. So I thought rather than spending too much time reviewing our current position, I would try to outline the main points of that outlook here. There is no question anymore that the recession ended in the third quarter and that we are experiencing a strong and vigorous rebound; we are still forecasting about 5% growth in the third quarter and 3.5% in the fourth quarter. Financial markets have been on a tear in recent months, driven by improving expectations and an abundance of liquidity provided by the Federal Reserve. The main economic policy focus in the U.S. is the high rate of unemployment, which has increased more than 5 percentage points to a 26-year high. Unquestionably, the fiscal stimulus will remain in place and may well be increased, or future disbursements could be brought forward to boost the creation of new jobs. Demand for the Federal Reserve's liquidity facilities dropped significantly in the past few months, which signals the liquidity crisis in the banking system is behind us; the collapse in the spread between LIBOR and Treasury Bills confirms improving liquidity conditions. At the same time, asset markets are rallying, fueled by abundant liquidity, and the dollar has weakened sharply as a result of low short-term interest rates. Against this backdrop, we have been predicting -- or rather prescribing -- that the Federal Reserve ought to start raising interest rates sooner rather than later. This would send a strong signal -- especially to bond investors -- that it will not allow inflationary expectations to become unhinged in the face of rising commodity prices, rallying asset markets and surging fiscal deficits.

To prepare financial markets for an impending rate increase in the first quarter, the Federal Reserve is likely to remove the phase "economic conditions are likely to warrant exceptionally low levels of the Federal Funds Rate for an extended period" following the next FOMC meeting in early November. We expect financial markets will react to an upcoming change in monetary policy with increased volatility. However, we strongly believe higher short-term rates are a necessary condition for a sustainable and stable upward trend in stock and credit markets, rather than allowing another liquidity bubble to build. Potential upward pressure on Treasury yields will remain contained by a central bank stating categorically that inflation is not an option, which in turn should support mortgage rates, and, therefore, housing markets. Failure to do so could lead to a bigger sell-off at the long end of the Treasury market, threatening housing and corporate borrowing. The Reserve Bank of Australia laid out three arguments that apply to all central banks beginning to raise interest rates. Firstly, the reason for cutting interest rates to record low levels was the risk of a deep and prolonged global recession, which did not materialize. Secondly, the outlook for the economy has improved markedly, just looking at consensus forecasts for next year. Thirdly, even after several rate increases, short-term interest rates will remain extremely low and should not impact economic activity materially. What higher rates will do is raise the price of money and stifle financial speculation. Many commentators believe the Federal Reserve will wait with any rate moves until employment improves. We expect that condition will be satisfied by December, when payroll growth should turn positive again. The relationship between employment declines and the drop in GDP during recessions

since the end of World War II suggests businesses cut about 1.7 million too many jobs during the current downturn. This also explains the stellar productivity growth corporate America is enjoying right now. We don't expect all of those jobs will come back immediately, but it seems conceivable that employers will hire back a few hundred thousand workers in the next six to eight months, as they adjust their businesses to the recovery.

Markus Schomer, Global Economic Strategist for PineBridge Investments, is responsible for providing macro-economic forecasts, analysis and commentary for all PineBridge Investments groups, with a focus on global economic trends and their impact on financial markets. He holds degrees in Economics from the University of Bonn in Germany and the University of East Anglia, in the UK. He also studied at the London School of Economics and is a Chartered Financial Analyst.

Looking at the trajectory of economic growth next year, rising short-term interest rates and more volatile equity markets are just part of the story. The fiscal stimulus, as it flows through the national accounts, will turn into a headwind in the second half of next year. In addition, we assume the inventory cycle will fade after next summer. As a result we are forecasting a significant slowdown in the third and fourth quarters of 2010. However, this will not herald a new period of economic weakness, but merely represent an "echo" of the sharp rebound we are experiencing right now. Looking out further, we expect that starting in 2011 the U.S. and the global economy can embark on a more durable expansion driven by real income and profit growth.

Investment Outlook

We maintain a positive risk posture in most of our portfolio in the current environment, as long as liquidity remains a key driver of asset markets. Our preference for emerging market equities is undiminished, given the region's strong economic fundamentals. The weakness of the U.S. dollar adds to the relatively stronger outlook for international assets based on domestic markets. The direction of allocation changes in our fixed income credit strategies follows a similar direction. Our risk appetite for higher yielding asset classes hasn't changed much in recent months, but we have been gradually increasing our exposure to emerging market bonds at the expense of mortgage-backed securities (MBS) and U.S. high yield bonds. Equity markets should generally still benefit from the confirmation of strong growth in the form of the third-quarter GDP report at the end of the month and further positive earnings reports in the coning weeks. However, the potential change in monetary policy could start a period of consolidation in U.S. equity markets, allowing fundamentals to catch up with the sharp run-up in stock prices.

Past performance is not indicative of future results PineBridge Investments is a group of international companies that provides investment advice and markets asset management products and services to clients around the world. PineBridge Investments is a service mark proprietary to PineBridge Global Investments LLC. Services and products are provided by one or more affiliates of PineBridge. Certain information may be based on information received from sources PineBridge Investments considers reliable; PineBridge Investments does not represent that such information is accurate or complete. Certain statements provided herein are based solely on the opinions of PineBridge Investments and are being provided for general information purposes only. Any opinions provided on economic trends should not be relied upon for investment decisions and are solely the opinion of PineBridge Investments. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements that do not reflect actual results and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial information. Any opinions, projections, forecasts and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. PineBridge Investments is not soliciting or recommending any action based on any information in this document. PineBridge member companies, including those mentioned herein, are in the process of changing their legal names to include the word PineBridge. PineBridge Investments Europe Limited is authorised and regulated by the Financial Services Authority ("FSA"). In the UK this communication is a financial promotion solely intended for professional clients as defined in the FSA Handbook and has been approved by PineBridge Investments Europe Limited. 10/09


PineBridge Investments - U.S. Market Watch October 19, 2009

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PineBridge Investments - U.S. Market Watch October 19, 2009