MARKET COMMENTARY

Following six successive quarters of economic contraction, the UK finally emerged from recession during the last quarter of 2009. Helped by official interest rates remaining close to zero, £200bn of quantitative easing, the temporary VAT cut and resilient levels of government spending, the UK economy limped out of recession. The economy grew at an estimated 0.1% during the final quarter of 2009.

On the corporate front the long-running Cadbury takeover saga appeared close to its conclusion after the UK confectionary maker accepted an improved share offer of around 850p from Kraft. Meanwhile initial gains in the banking sector as RBS and Barclays won positive broker comment were subsequently reversed as investors reacted to the US bank breakup proposals, despite mixed reactions from UK political parties.

On the economic newsfront a better-than-expected unemployment report was followed by news that the economy returned to growth in the final quarter of 2009. News that consumer price inflation jumped to 2.9% in December from 1.9% in November sparked some concerns that the medium-term picture is less benign than many had predicted, even raising the prospect of an interest rate hike. Meanwhile disappointing retail sales figures served as a reminder that consumers shouldn’t be relied on to drive the economic recovery.     

January’s batch of economic data painted a picture of a hesitant recovery in the world’s biggest economy. December’s jobs report was particularly disappointing, showing that 85,000 jobs were shed during the month, dashing hopes that November’s encouraging report heralded the turning point for the jobs market. Despite the fledging US economic recovery, unemployment levels in the US are hovering around 20-year highs, posing a major challenge for the Obama administration.

Meanwhile, US retailers had a relatively tough festive season as December retail sales unexpectedly dropped by 0.3% from November’s level, taking the total fall in 2009 retail sales to 6.2% compared to 2008. Data also showed that wholesale inventories climbed by a stronger-than-expected 1.5%, suggesting that the anticipated pickup in final demand is still lagging behind material supply, despite some more encouraging recent suggestions that inventories had been overly run down. However, the sixth consecutive monthly gain in the Standard & Poor’s Case-Shiller house price index and a rise in consumer confidence suggested that the improving mood is gradually feeding through to support asset prices.

While economic data broadly confirmed that the recovery in the ‘core’ Eurozone is continuing, notably in export-dominated Germany, fresh signs of strain emerged in the 16-nation bloc. Amid on-going concerns over the finances of some Eurozone countries, such as Greece and Portugal, European Central Bank (ECB) President Jean-Claude Trichet warned that rising debt is a major problem for European governments, and that the Eurozone recovery could be “chaotic” and inconsistent. President Trichet also appeared to distance the ECB from Greece’s troubles, reminding markets that Greece needs to “do its own work” and called for further reforms in the Irish economy to reinforce competitiveness.

These stresses seemed a world away from the improving trading environment noted by German companies, with the closely-watched economic indicator – the Ifo Business Climate Index - climbing for the 10th successive month in January, hitting its highest level for 18 months. Sentiment was particularly strong among manufacturers as companies anticipated a pronounced recovery in exports.

A January report from the Bank of Japan observed that economic conditions are improving, yet the recovery remains dependent on ongoing government support measures. The central bank’s board kept interest rates on hold at 0.1%, noting that while the outlook for exports is improving, domestic demand remains muted, with a heavy reliance on support from the debt-ladened government.
 
Though the bank revised its Gross Domestic Product forecast for the present financial year from -3.2% to a -2.5%, the board expressed a very pessimistic note on deflation, warning that Japan faces three years of falling prices.

Meanwhile, the yen recovered some of the ground lost against the dollar. A stronger yen versus the dollar is bad for Japanese exporters as it can erode overseas earnings.

Data released in January provided further confirmation that China is firmly in the driving seat of the global economic recovery. The Chinese economy grew by a breakneck 10.7% in the fourth quarter of 2009, lifting growth for the full calendar year to 8.7%.

According to most estimates, China is now on the cusp of overtaking Japan as the world’s second-largest economy. Buoyed by massive state infrastructure spending, the country’s domestic economy continued to fizz amid fresh signs of soaring consumer activity, with the latest sales data suggesting that China accounted for an amazing 25% of global car sales in November. However, following recent calls by the Chinese Prime Minister for banks to adopt a “more balanced” approach to cool the danger of asset bubbles in areas such as property, the central bank imposed new reserve requirements on banks with a view to curbing soaring lending activity.

Though intended to help achieve a more sustainable medium-term rate of economic growth, these measures, amounting to an effective tightening, had a knock-on impact on sentiment across other emerging economies. The commodity-rich Brazilian market pulled back from its strong start to the month, weighed down by the prospect that slower growth in China and elsewhere could cap global demand for Brazilian exports.

Though inflation remained relatively subdued by historical standards, firmer-than-expected food and beverages prices raised the prospect that interest rates could rise earlier than the market’s present Q3 consensus. Nevertheless, Brazil’s central bank is forecasting economic growth of 5.8% this year, while China has targeted growth of 8.3%.
 

Having risen sharply towards the end of December amid growing concerns over some countries’ deficit woes, government bond yields eased back in January on fresh signs that the pace of the global economic recovery, particularly in the developed markets, is likely to be relatively mild.

A second downgrade to US third quarter GDP, taking growth down from the original 3.5% estimate to just 2.2% on an annualised basis, subdued retail sales and a setback for the jobs market combined to support sentiment to US government debt. News that President Obama is targeting a three-year public sector pay freeze to help tackle the US deficit also supported confidence in US Treasuries. Yields were also broadly lower in the ‘core’ European economies, such as Germany, though yields climbed in Greece, Spain and Portugal, reflecting the market’s ongoing unease over these countries’ efforts to tackle their deficits. Though economic data in the UK struck a more encouraging note, signs of a growing political consensus over the need to address the budget deficit helped to support the gilt market following its poor end to 2009. However, Japanese government bonds remained under pressure on lingering concerns over the levels of state spending as the government grapples to sustain the recovery.

Corporate bond markets gave back some of their recent gains towards the end of the month as investors reassessed risk on concerns that Greece’s debt woes could be contagious and the surprise banking reforms lined up by President Obama. The softer trend was most apparent in the new issues market, with a number of new issues from lower-quality borrowers slipping noticeably in the secondary market.