26 Oct 09 Out of the Woods? Is the global economy experiencing a true recovery?

Economic theory teaches us that in a recession, resources such as workers, factories and unexploited research lie sluggishly by as demand falls short of supply, but when recovery arrives the economy will grow faster than normal for a period until it reaches full potential again. The market is certainly feeling optimistic as asset prices are going up from gold to Treasury bonds, output has stopped shrinking in many of the world’s major economies and, according to the IMF, world GDP is expected to expand by 3.1%, revised upwards since April. Profit forecasts have also been revised higher with a general consensus amongst analysts that there will be 28.7% increase in global corporate earnings in 2010. However, as people breathe a sigh of relief for the worst is over, the apparent recovery is not all it seems.

A paramount reason why the stock markets have rallied is due to strong government intervention that has caused enormous fiscal deficits and near-zero interest rates. Equity and corporate bond markets have been boosted by quantitative easing, a process in which central banks print money to purchase government bonds which has kept a cap on Treasury bond yields, leading to the fear that recovery has mainly been driven by liquidity. Unemployment rates are still rising, debts are worryingly high and banks are in dire need to replenish their capital.

The effects of the recession on AIM have also been notable. Up to 33% of companies were forced to delist in the year to March 2009, due in part to difficulty in raising cash on the market and with banks unwilling to lend. Another factor that has weighed on AIM is the decrease in the choice and availability of NomAds, as many have been taken over by large competitors or have resigned due to the high legal, regulatory and reputation risks with small cap stocks. Marcus Stuttard, Head of AIM, expects his market to raise approximately £3 billion for 2009, which is a far cry from the £16 billion raised in 2007.

AIM, however, still remains attractive to smaller companies and investors. It has come a long way since the collapse of the ‘dotcom’ boom and now attracts some of the world’s leading institutions, as well as private investors. In recent years, the market has also attracted increasingly more companies from developing economies, thereby strengthening the City’s links with emerging markets.

Despite the high risks involved in investing on AIM, there is a low outright failure rate of less than 3% during ‘normal’ times, according to a London School of Economics study (September 2007). An analysis of aftermarket returns on new admissions since 2000, suggests that on average, investors in AIM companies have outperformed the wider market with AIM gold stocks leading the way. As confidence in the world economy grows, there will be decreasing reliance on the dollar and the weakening of the dollar will play a key part in the rally of gold. It could also be said that the PLUS market has been ‘cleaning up’ AIM by taking on many stocks at the lower end of the scale while companies on the upper end have liquidity levels comparable to some of those on the main market.

With the current recovery path fuelled by liquidity, fears are emerging regarding a ‘double dip’ recession. Bulls may choose to believe in a self-prophesising market, as investors regain confidence out of sheer relief that the market appears to be out of turmoil. Recovery is currently dependent on massive fiscal and monetary stimulus while it is questionable whether the underlying causes of the mess have been resolved. When quantitative easing inevitably stops, yields will rise sharply, driving up the borrowing costs for everyone.

Emerging markets should play a key role in the global economic recovery. Emerging stockmarkets are up by 62% since the start of the year and developing nations will grow much faster than their advanced counterparts. Asian economies have rebounded faster than any other region, yet most of their currencies have fallen since 2008 in real trade weighted terms, leading to the conclusion that Asian currencies are among the most undervalued.

What needs to be done going forward is a delicate rebalancing act between developed economies high in trade deficit and emerging economies with huge surpluses leading to a currency appreciation for emerging countries. There are also calls for larger financial institutions to pay higher premiums into a US fund targeted to insure against potential future bank failures. A change in accounting is also needed, as the previous system allowed banks to hide substantial losses. Governments should tackle unemployment and avoid over protecting specific industries. Allowing the market to ease and adjust itself will do more to boost productivity in the long term and it is only then that we will be able to pass through the storm.

Written by City Equities Ltd Research Dept.

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