Pru's Martin Brookes on the global recovery

Western governments need to convince markets they have credible plans to reduce debt so that a much-feared double-dip recession does not materialise.

After the unprecedented shock treatment for the global economy, governments and central banks are counting the cost and looking for exit strategies that will ensure the feared ‘double-dip’ recession does not materialise.

It is clear the size of the fiscal and monetary stimulus delivered by governments and central banks cannot be funded indefinitely without risks. The IMF’s World Economic Outlook forecasts that most developed economies are likely to see their total debt ratio approach 100% of GDP in the next few years. In the UK, the speed of the deterioration of the budget deficit has been particularly marked, given the relative importance of the banking sector to government revenue.

However, the stimulus did help deliver a return to growth. The trillion dollar question now is whether the private sector can generate enough demand to replace the government stimulus.

The levels of debt themselves are not especially problematic, in the sense there is not a realistic likelihood of default by major western governments. They need to convince the markets they have credible plans to reduce debt, and we would expect the spending cuts and tax rises to start in earnest in 2011.

Of course, timing is important. If governments cut too soon they risk harming recovery, while if the authorities wait too long they could stoke inflation and asset price bubbles.

Private-sector confidence?

In an ideal world, the private sector will strengthen sufficiently over the next year to underwrite the safe exit of government and central bank stimulus. As confidence improves, self-reinforcing mechanisms help sustain a virtuous cycle of improving trends in the economy and improving government finances. That remains the most likely outcome; given the extent of the downturn, it is not inconceivable that such a recovery is surprisingly strong next year.

Legacies of the recession

However, the recession and banking crisis have left two legacies that could hinder the typical cyclical recovery. The banking system still faces credit losses and is coping with uncertainty about asset values. This is almost certain to restrain lending in the year ahead and limit the credit-induced boost that would normally occur at this stage of the economic cycle.

Capital markets have helped create credit, although new corporate bond issuance and the ABS markets in the US have shown signs of recovery. This brings us to the second legacy:banks’ lending is constrained, but so is consumer demand for credit. Deleveraging by households will continue into 2010, and sustained higher levels of saving to reduce debt levels could continue to restrict consumer spending.

These two hangovers from the recession and credit crunch make it likely the recovery will be more subdued and bumpy. However, we strongly believe a relapse can be avoided and put a low possibility on a double dip next year.

Inflation is likely to remain low, so it is more probable governments and central banks will be cautious about raising interest rates. The private sector also has the capacity to start spending again. Companies reacted with astonishing speed to cut costs to protect margins in the recession and from a low base can start modestly improving capital spending.

Valuations on equities, credit and commercial property are now broadly in a ‘fair value’ range, which means they are priced to deliver an appropriate risk premium. For equities, this means they are priced to deliver a 6% real long-run return, while BBB-rated corporate bonds should earn about 4%, and commercial property about 5.5% real. The risks from consumer deleveraging and credit creation point to a real risk of growth disappointment over the medium term, and that risk is heightened by the recent dramatic improvements in consensus company earnings forecasts.

Investment grade attraction

Our view is investment-grade corporate bonds now look more attractive compared with equities. Within equities, our preference is for the UK and Europe. The growth outlook is better in the Asian and emerging markets, but valuations look up to speed.

In the fixed-income markets, investment grade credit spreads – excluding financials – remain reasonable value, while the very high grade US CMBS are attractive. Spreads in the high-yield markets are up to events, while yields in the major government bond markets look expensive.

There is good value in the UK commercial property market, but prices look expensive in city offices.

The private sector can improve to offset the winding down of government and central bank stimulus programmes, but the economic recovery is likely to remain subdued and volatile.

Martin Brookes is director of portfolio management group at Prudential.