The raft of rescue measures taken since Lehman Brothers was left to sink in mid-September has brought some improvement, but there is still a long way to go. Governments throughout the entire (western) world have since indicated in no uncertain terms that they will do whatever it takes to keep the financial sector afloat. Although additional measures are necessary, confidence in the sector will return in the end.

The world economy is slipping into recession

The economic superpowers in the west are all at this stage, while more and more disturbing signs are appearing in the emerging markets. The recessionary climate will last a few more quarters at least, which means there is still much bad news to come on the economic front.

From inflation hype to deflation fears

In the wake of falling oil prices, inflation will continue to cool off spectacularly in the months ahead, even slipping well below zero in a number of countries by the spring of 2009. Temporary negative inflation does not necessarily mean there will be damaging deflation. Although the risks of this have clearly increased, aggressive government action should prevent such a doom scenario from materialising.

Recession won’t last forever

Unlike earlier crisis periods, such as in the US in the 1930s and in Japan in the 1990s, governments now take a much more pro-active and wide-ranging approach to tackling the problems. Intervention in the financial sector together with the provision of massive monetary and budgetary stimuli should ultimately turn things around. Even so, structural corrections are required in a number of areas (credit and property market, US household finances) that will continue to weigh on growth for some time to come. The global economy should be over the worst in the second half of 2009, but any recovery will be a modest one.

Outlook for the financial markets

Cash

The nominal return on cash rose sharply during 2008, due to fears about inflation in the first half of the year, culminating in the ECB hiking rates for the last time in July, and the further widening of spreads on the money market, primarily after Lehman Brothers went bankrupt. On 8 October, the three-month Euribor rate peaked at 5.4%. Since then, calm has to a certain extent returned to the money market.

Although the spread is still very wide, it is still roughly 30 to 40 basis points below the peak in October. Moreover, market expectations about the ECB’s policy have shifted dramatically. Further aggressive rate cuts of up to 1.5% are on the cards in the months to come. If confidence in the money market gradually continues to improve as well, the return on cash investments will fall to approximately 2% as early as the opening months of 2009.

Bonds

Government bonds have been exceptionally robust. Since peaking in July, the German ten-year rate has fallen by roughly 150 basis points to approximately 3.10%, leaving it very close to its previous low of 3.02% in September 2005. Against the backdrop of negative growth, low inflation and the ECB making further rate cuts, the bond rate might be expected to slip further towards 2.50% in the first half of 2009, with the result that government bonds would significantly outperform cash in the months ahead. In the somewhat longer term, corporate bonds in particular will show considerable potential. Since Lehman Brothers went to the wall, spreads on investment-grade bonds in euros have doubled again to almost 500 basis points above government bonds with a similar term. This means that investors are pricing in a much worse scenario than the Great Depression of the 1930s. That is excessive. Once some calm returns to the financial markets, this asset class could generate a return of 15%-20% in quite a short period of time.

The stock markets have had their worst year since 1931 and as a result, share prices have become extremely attractive, even should the very weak economy cause earnings to fall further in the coming quarters. Stock markets tend to anticipate economic developments. Accordingly, a scenario in which there is a cautious economic recovery from the second half of 2009 on implies that shares will hit a low in the next few months. Given the high volatility on the markets, however, caution remains advisable and investments should be made gradually.

US dollar

Since hitting a low in the early months of 2008, the US dollar has recovered strongly against the euro. Even so, the currency is still roughly 10% below its long-term fair value. Moreover, the economic scenario for the coming two years could turn out to be beneficial to the US, which means that the dollar has some additional potential.

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	Spotlights

	22nd out of the top 500 banks with biggest loan portfolio in the first half of 2009 (RBC, August 2009)

	5th in terms of volume of consumer loans issued in 2009 per outlet (RBC, March 2009)

	19th among Russia’s biggest brokers in 2008 (RBC, February 2009)

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