The shape of things to come

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This document is dated 1 June 2009 and has been prepared for the use of licensed financial advisers only, based on sources and information which we believe to be reasonable. The information in this document is intended as general only and accordingly it does not take into account any individuals objectives, financial situation or needs. In no circumstances is it to be used by a person for the purposes of making a decision about a financial product or class of financial products.

There is growing evidence that most economies around the world are beginning to turn after the events that scuppered growth in late 2008.

Production appears to have bottomed in key manufacturing nations such as Japan and Germany, with trade also beginning to pick up in more export-oriented nations such as Korea and Singapore. Even Europe, which many have considered to be in the worst situation, has shown signs of improvement with leading indicators starting to turn in the last few weeks.

On the up?With the wider consensus now predicting the start of recovery, the debate has shifted to what shape that recovery will take. Optimists suggest that, given the positive signs already seen in the economy and that the support from fiscal and monetary policy is still in train, economic activity is likely to enjoy a V-shaped recovery.

The pessimists would argue, however, that there are still many fundamental problems with the banking system and the structure of global activity, and that a strong recovery cannot be sustained, leading to a U-shaped or W-shaped recovery. For the more imaginative, some have suggested that it will be an “upside-down square root sign” shaped recovery.

The inflation debateWhile this particular debate is likely to continue for some time, the inflation debate has shifted markedly. The fear of deflation in the US has all but disappeared, which is exactly what the Federal Reserve was aiming for when it introduced its extraordi-nary measures to support the economy and markets. With government debt levels now soaring, many are now concerned about the prospect of run-away inflation.

Markets have been very quick to respond to these changing views. Equity markets have enjoyed a healthy rally since the lows in March, and long-term bond yields are rising fairly rapidly in response to rising inflation expectations, albeit from extremely low levels.

The star performers have been markets with commodities exposure. Base metal prices have recorded strong gains, while contract commodity prices have been rolled over at better than expected levels. The A$ has benefited from this positive momentum and sentiment, rising around 10% over the month of May.

Regionally speakingGiven the extraordinary events that led to the downturn, how the recovery will pan out is still very uncertain. One thing that is already starkly clear is that different regions have been affected in different ways.

In the US and the UK, it has predominantly been a ‘sudden stop’ in credit markets that has undermined the economy, with a potentially lengthy healing process. In countries such as Germany, Japan and in export-oriented countries in Asia, it has been a ‘sudden stop’ in manufacturing that has been the problem. But as inventories are drawn down, production can again resume at higher levels, ensuring that growth will pick up at a reasonably rapid pace.

The production level, however, will be much lower than it was before the crisis. It is difficult to grasp the magnitude of the decline in production across many parts of world in the last 6 months. While growth will undoubtedly improve, because it is coming from a very low base it may be some time before many of us feel it the effects.

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