Ralph Leib Senior Investment Strategist 2008 will be remembered for the severe downturn witnessed in financial markets. Global shares experienced their second largest fall on record, as the initial sub-prime credit crisis in the US broadened into a large-scale global credit and liquidity crisis.  Many leading financial institutions such as Bear Stearns and Lehman Brothers, which had survived the 'Great Depression', collapsed under a burden of write-offs and losses that wiped out their balance sheets. Fortunately, GESB's fund managers have had limited exposure to these institutions and direct portfolio impact has been immaterial.   In the UK, the banking system came close to collapse before the UK Government moved to support the sector by taking material ownership stakes in a number of financial institutions.

To date, global financial institutions have written off over US$1 trillion against failed investments (or 'toxic assets').  These institutions have sought to repair their balance sheets using additional funds received from central banks, sovereign wealth funds and shareholders.  The US Federal Reserve alone has been forced to use in excess of US$7 trillion to support the crippled US financial system.

Putting 2008 into perspective, in excess of US$30 trillion has been lost from share prices globally, with current valuation levels last seen in 2004. 

It is useful to look at the 2008 market contraction in the context of previous 'bear markets' (a market condition of a prolonged period in which investment prices fall more than 20%, usually accompanied by widespread pessimism).  
 
For example the calendar year 2008 decline of 39% by the US S&P500 Index was the second worst on record, with only 1929, the start of the 'Great Depression', being worse.  Over the past 100 years, there have been 32 bear markets (or one every three years), that last 14 months on average though the 1930/1932 bear market lasted 27 months. The current bear market that started in Oct/Nov 2007 is already 15 months in duration.

The outlook

As we stand at the beginning of 2009, the global credit crisis has developed into a global economic crisis. All of the world's leading industrial nations are already in recession and unemployment is increasing. Domestically, Australia has fared relatively well but remains at risk from any further material slowing in Chinese economic growth.   

The Australian Government and Reserve Bank of Australia (RBA) remain well positioned to provide stimulus to a slowing economy. The RBA is likely to cut interest rates further, perhaps to 3% or even lower, which will lend support to the domestic housing market and provide much needed relief to the Australian consumer. The Commonwealth Government has already announced an economic stimulus package, which is likely to be expanded further over the coming months.

There are three potential economic outcomes at this stage:

1. A rapid economic recovery that takes place over the next 6-9 months;
2. A more prolonged recession, lasting until the middle of 2010; similar to the 1970s; or
3. A 'Great Depression' scenario with global unemployment peaking at over 20% and economic growth falling more than 10% p.a., similar to 1929-1934.

Currently, market analysts believe the most likely outcome is b, a more prolonged recession, as financial institutions and households rebuild their balance sheets and reduce borrowings.  From an investment perspective, this means continued fluctuations in the equity markets, with the timing of recoveries notoriously difficult to predict. Historically, the first year of a major economic downturn is usually accompanied by the largest equity market fall (see Fig. 1).  Acknowledging that this economic contraction began at the end of 2007, then perhaps a moderation in equity market losses is a reasonable expectation.

Fig. 1 -Performance of the Dow Jones in the first year of major corrections since 1900

Source: http://www.chartoftheday.com/

At times like these, members should take comfort that GESB's Investment Team remains focused on meeting the risk and return objectives of our various investment plans. While fulfilling this important role, the team actively monitors the external fund managers in terms of their processes, performance and risk on a daily and monthly basis. The investment team makes sure the portfolio continues to have exposure to traditional asset class groups such as fixed income, equities, property and cash. We are also reviewing potential investment opportunities in asset classes which have been affected by the global credit/economic crisis. This investment activity serves to position the portfolio for the long term and ultimately for financial market recovery - when it occurs.

Past performance is not an indicator of future performance.