November 2009

It seems that investors are already beginning to have doubts. After the relief experienced when the recession was declared over, they are asking questions about the pace and sustainability of economic recovery. Many are also starting to wonder exactly how central banks will go about normalising their highly accommodative monetary policies.

Although investors were relatively sanguine in response to the first increases in policy interest rates, by the Bank of Australia in October and November and by the Bank of Norway in late October, no doubt because this tightening was in response to stronger than expected economic conditions, they are increasingly focusing on what the US Federal Reserve and the Bank of England might do next. They currently seem less concerned about the European Central Bank’s plans, no doubt because it has not gone as far as its two counterparts in making direct purchases of debt securities to ease credit conditions.

This skittishness is likely to increase volatility in equity, bond and currency markets, although stress indicators will probably not reach the extremely high levels seen over a year ago when the financial system broke down in the wake of the Lehman Brothers bankruptcy. Although it is of course in the interest of central bankers and the global economy that "exit strategies" are conducted as smoothly as possible, their task is complicated by the often novel nature of the policy measures implemented, the amounts involved, uncertainties as to the speed of economic recovery and inflation expectations. Ben Bernanke has adopted a relatively reassuring stance for the time being but it is still too early to determine whether he will be believed and whether circumstances will enable him to normalize monetary policy as he intends.

Beyond these considerations of monetary policy, economic conditions will probably continue to be favourable to equity markets over the near term. Investors however are still far from reassured. Price variations day-to-day and even intraday have been substantial over the past few weeks and volatility has increased a bit. Investor hesitation can also be seen in their response to third-quarter earnings reports, which although stronger than expected were greeted with less enthusiasm than were the second-quarter reports released over the summer. Whereas the MSCI World index gained 8.7% in July, it decreased 1.6% in October. This contrast may be largely explained by the slowing of economic momentum. The economy's “good surprises" for this cycle peaked in late June and early July and although the net balance is still positive this indicator has been moving trendlessly ever since.

This environment is not necessarily negative for equity markets, since they are correctly valued and security analysts continue to raise their earnings forecasts. We believe that equity prices have not completely exhausted their upside potential.