The Glass Half Empty

MLC MARKET INSIGHT

09/2010 Summary

The post GFC investment environment – What can history tell us?

If you ignore history then you’re doomed to make the same mistakes.

The recent bout of financial market nervousness serves as a timely reminder to investors of the unusual nature of the challenges facing investors in the current cycle. Renewed declines in equity markets of between 10 and 15% from their April 2010 peak to late August 2010 reflect a broader escalation of concern about the next stage of the global economy.

Whilst the GFC has in many ways been compared to the Great Depression, at least thus far, it is yet to resemble the same magnitude. To put it into context, US GDP growth fell peak to trough by just under 5% through the GFC whilst the Great Depression experienced a peak to trough decline in excess of 25%. Nonetheless the impact on the US and global economies of the GFC has been particularly severe as has the still unfolding impact on investor returns.

Peak to trough decline in US GDP – GFC vs Great Depression

Up until the Global Financial Crisis (GFC) of 2008/09, as investors we haven’t really thought too much about these previous periods of history.The belief in a more sophisticated global economy and financial system, and greater confidence in the management of them has led to widespread complacency and an ignorance of many of the lessons from these extraordinary periods.

Lessons from history

What lessons can be drawn from the recurrence of banking crises through history that may assist our understanding of the post GFC environment? The most fundamental are that the

impact and duration of the crisis on an economy and the financial sector is largely a function of three factors;

1. How severe the asset bubble was;

1. How significantly affected is the banking sector by the asset bust; and

1. How aggressive and ultimately successful the remedial actions by Governments are to stabilise and rebuild the banking sector post crisis.

Using this rule of thumb, the GFC ranks high on the severity scale. However, is there anything that gives us more comfort that the workout of the global banking system, economy and financial markets post-GFC will be less severe and more rapid than history suggests?In the case of the Great Depression, inappropriate monetary and fiscal action (or inaction) by governments and authorities globally in the early 1930’s turned a recession into a decade long deflationary Depression.

Now, the policy response to the GFC means the situation is unclear. The initial emergency measures to prevent widespread bank system collapse have helped to stabilise conditions thus far. However, the failure to remove bad loans from bank balance sheets particularly in the US,could see banks struggle to recover. This is a major concern suggesting the potential for a “muddle through” work out at least for the next 2 -3 years rather than the quick recovery hoped for.

Under the ‘muddle through’ scenario, risk assets such as equities may struggle to appreciate above the 2007 highs for an extended period of time. Nonetheless, this scenario suggests that quality risky assets can still provide reasonable returns but they should be used with a more conservative view of outcomes.

Strategies that seek to achieve a reasonable level of return with a perhaps more moderate or efficient exposure to risky assets could be employed. Some suggested investment strategies for the “muddle through” scenario are:

1. Diversification
2. Dollar cost averaging
3. Active investment management (security selection)
4. Risk aware strategies that focus on the absolute return potential offered by high quality investments
5. Secure and stable income returns from high quality assets including equities

The current uncertainty in the global economy is going to be around for a while, with lots of bad news interspersed with nuggets of good news. This will likely result in greater ongoing financial volatility coupled with more modest investment returns. Having the right investment strategy is crucial to successfully navigating this period.

If you would like to discuss the paper further, please call any of our investment specialists listed below.

Andrew Connors(02) 9376 5377John Owen (02) 9936 4590

Natalie Comino (02) 9936 4538Kajanga Kalatunga (02) 9936 4537

Marius Wentzel (02) 9376 4549

Or email us at

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