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Can an abnormal downturn result in a normal recovery?

Financial markets have entered a new phase. The strong gains in the past months have largely been the result of investors discounting the end of the recession and the credit crisis. With market valuations having normalised, the focus now turns from the timing of a recovery to the estimation of the strength of this recovery.

This is a topic about which investor’s opinions diverge widely. Some of the big US brokerage houses expect a fast return to the high levels of economic growth seen before 2008. Another group, among which we would count ourselves, thinks that abnormally deep recessions do not generate normal recoveries and sees a more modest “below trend” growth-outcome as more likely.

The dissention among investors is to some extend visible in financial markets, with cyclical stocks going through the roof and, at the same time, government bond yields continuing to decline. This cannot go on for much longer, since low yields on long dated governments bonds are indicative of a world with no or very low inflation, an environment in which cyclical companies tend to have insufficient pricing power and revenue growth.

The debate among investors centres on the role of the consumer and the effect of low money market rates. With Bernanke’s term having been extended it is likely that official interest rates will remain low for some time to come. This is good news for risky assets, since investors are not highly rewarded for holding money in the bank. This is one of the factors which have helped financial markets to react so euphorically to the better than expected data.

However, in order for this recovery to be strong and sustainable, investors will need the help of the consumer. After all, consumption is responsible for 60 to 70% of GDP in the developed world. We are sceptical about the likelihood of a “normal” recovery in consumption, after this abnormally deep recession. Why?:

- Consumer balance sheets are still burdened by more debt than ever before, certainly in the Anglo Saxon world.

- Consumers are getting used to low interest rates, they have been enjoying them for most of the past decade. Low rates will not incentivize spending as much as it did in the past.

- Consumers in the developed world are getting older. The US and Europe are now entering a period of adverse demographics. Older consumers tend to buy less (housing related) goods, as can be seen in Japan. This effect is partly compensated by the growth in emerging market consumption, but for now emerging markets are only responsible for 25 to 30% of global consumption.

- Western consumers will likely be faced with very low real wage growth in 2010 and 2011. Cost control will remain a strong focus among company managements.

- At the same time, consumers will be faced by continued upward pressure on commodity prices, caused by emerging market demand.

All in all, there is a good chance that the consumer upturn after this recession will be unusually slow and modest in size. This is reflected in our portfolios, where we are underweight in consumer related sectors (retail, auto’s, household goods, food and beverages) and overweight in services (telecom, utilities), energy and technology. On a regional level, we prefer Europe to the US, as European equities are clearly cheaper, have higher dividend yields and have a lower weight in consumer stocks.