IFS MARKET COMMENTARY
BACKGROUND
It is a mere four months or so since the US investment bank Lehman Brothers filed for bankruptcy, an event that would have been described as all but impossible only a few months earlier. That event is widely recognised as the point at which the powers that be, Governments and regulators lost control of the financial sector restructuring process.
The Lehman debacle and the ensuing collapse in economic confidence led to a sea-change in the global authorities' policy response. Previously, central banks were more concerned about inflation and avoiding an appearance of bailing out imprudent borrowers and lenders, to discourage imprudent activity in the future. Because their actions appeared piecemeal, reacting to crises at individual institutions, markets did what markets do, focused on the next most vulnerable institution after each "rescue". Consequently, all banks reacted by hoarding liquidity so they could defend themselves if they were identified as the next "target" and because of increased concerns about borrowers' ability to repay in a period of economic stress.
The breadth of the September collapse in market confidence was shocking and sudden and was allied to the complete seizing up of the lending markets. The realisation that the credit markets were in danger of total breakdown forced authorities to introduce policies that would have been inconceivable even weeks before. During the first half of October, a range of measures ensued to restore liquidity to the lending markets, with governments underwriting hundreds of billions for the banks, interest rates were aggressively cut and governments agreed to ease fiscal policy, even though in some cases deficits were already at high levels.
The shock of these weeks caused business and private consumers to cut back on spending, investment and hiring staff. Savings rose sharply, leading to a slump in new orders and economic activity. Whilst this has started to address the imbalances between deficit countries (such as the US and the UK) and those with trade surpluses, the pace of change has been painful, with fears that a "normal recession" could be tipped into a depression similar to the 1930s.
This period of economic contraction coincided with the strains on the banks caused by the end of the credit bubble, causing a particularly sharp squeeze on lending, with negative effects across the economy. A change in borrowing trends that could fairly be described as desirable if spread over a number of years could become a catastrophe if condensed into a single year. Prudent and well financed businesses and individuals can as a result be caught out along with those that are already overstretched.
The authorities' reactions to this worrying and unpredictable outlook have been threefold: reduce the cost of borrowing, increase the supply of liquidity to banks and boost spending. Although there are some signs these measures have stabilised the situation it is not yet clear whether enough has been done to reverse the destructive cycle of banks' losses prompting a squeeze in credit, causing a contraction in activity, leading to further losses and so on.
What does appear clear is a collective global determination to do "whatever it takes" to promote an economic recovery during 2009, to avert the risk of a prolonged slump. Whilst these appear correctly focused on the need to maintain a supply of credit and to ensure the capital strength of the banks, the missing ingredient is confidence, which does not respond mathematically according to an economic equation. A more encouraging bubble bursting has occurred with the oil price, which surged to an eye-watering $140+ a barrel in the summer and has since fallen back to $40.
The immediate outlook for financial markets will be the outcome of a tussle between the negative news on output and corporate earnings and the hope that unprecedented fiscal and monetary government input, aided by the collapse in oil prices, will improve trends during 2009 and create confidence that 2010 will be a better year. Although considerable pessimism is priced in, the twin pressures of recession and the credit squeeze present near-term risks, particularly for areas of the economy with high borrowings or uncertain revenues.
UK
The UK economy has slipped into recession and forecasts have been cut back sharply for 2009. The credit squeeze has made banks cut back on new mortgage lending, only available on demanding terms, and with house prices still falling the urgency to "get onto the ladder" has abated.
Consumer spending, fuelled by mortgage borrowing and cheap sources of credit, was a significant driver of the UK's boom period and that will have to change, UK consumers need to rebuild their savings. For those with jobs and mortgages, the fall in loan rates and oil prices will enable them to do so without undue pressure on spending. Those who lose their jobs, or fear doing so, will reduce their spending despite the relief of lower mortgage rates and fuel prices
The depth of 2009's recession and recovery (?) in 2010 will depend on the speed with which consumer savings are rebuilt and restoring a normal flow of credit, so creditworthy businesses and individuals are able to finance their plans. Further steps to boost the banks' capital strength and access to funds will be needed before the credit contraction is reversed.
The UK was particularly vulnerable to a credit-induced recession, owing to high levels of private debt and overextended house prices. Although the transition from 3% growth in 2007 to a forecast 1.5% fall in output in 2009 has been sudden, recent policy changes argue against becoming steeped in gloom. Base rates have been cut from 5.75% to 1.5% and seem set to fall further. These rates are beginning to percolate through to company borrowing costs and existing mortgages. Sterling has fallen sharply against its main trading partners, which will help exports, tourism and companies competing with (now more expensive) imports.
The government has embarked upon a series of temporary tax cuts and spending measures and, although this will have to be paid for eventually (by future taxes or spending cuts) it should help buffer the current downturn averting the risk of turning into a multi-year depression.
The fall in fuel prices will also help support spending in 2009 so the position for many individuals could appear much better by the end of 2009 than currently expected, while companies able to benefit from a competitive level for sterling (for the first time in a decade) should be able to win market share. Once the bottom of the global recession has passed (hard to predict, but could be in the first half of 2009) the UK stock market (with its substantial exposure to overseas earnings and resources stocks) could perform relatively well.
EUROPE
The European Central Bank's (ECB) interest rate strategy between July and October looks, with hindsight, to be a massive misjudgement of the scale of the financial sector's problems. When credit markets collapsed, European banks and insurers proved as exposed as their peers in the US and the UK.
A by-product of the credit crisis was increased concern about the ability of constituent members of the Euro to stay "in the club". The ECB's policy proved easier for economies (such as Germany) that had gained competitiveness in recent years than for those (such as Italy, Spain or Ireland) which had either lost competitiveness or had greater need of easier policy as a result of imploding real estate booms.
For governments sharing a common currency, their bond yields should be the same, which was virtually the case two years ago. Yields began to diverge significantly in mid 2008, as economic growth slowed and concerns about property and credit markets grew. Markets are currently pricing in a 13 to 14% devaluation by Ireland and Italy over the next 10 years putting pressure on the euro "club".
Policy disagreement is already evident over the extent of economic stimulus needed and, if Germany (the main country in surplus) continues to hold out against significant fiscal stimulus and the ECB drags its feet in delivering lower rates, this may increase further. The Euro depends upon the electorates in its constituent countries accepting the overall merits of being in the currency union and their loyalty will be tested if the European economy remains mired in a prolonged recession.
European equity markets have corrected sharply but the currency remains at overvalued levels against its major competitors (Although the correction here has already begun in early 2009). This either suggests a greater than average risk of profits disappointing or that the ECB will declare victory over inflation and cut rates to levels prevailing elsewhere.
UNITED STATES OF AMERICA
In common with other regions, the economy appears to be in freefall, as the banking collapses in the autumn have stalled consumer spending and investment, while the recapitalised banks have tightened lending criteria, seeking to avoid more losses.
Although it is clear that (since Lehman Brothers) the Federal Reserve (the Fed) will not allow systemically important banks to fail but they have little control over lending policies. The key is a restoration of confidence, and this could be where the new administration and an inspirational new president may have a key role to play.
The US housing market was the initial cause of the banking crisis so it would be both symbolically and financially important if this market were to bottom out in 2009. For the last two years, builders have been scaling back construction but this has been more than matched by reduced buying. The recent price corrections, together with falls in mortgage rates, has restored affordability to the best level in 30 years.
The Fed, by directly purchasing loans underwritten by the government housing agencies is reducing the rate at which mortgages are offered to new buyers. Political initiatives are directed at reducing home foreclosures, and prices have already corrected sharply, especially in overheated boom regions such as Florida and California. Mortgage refinancing applications are rising sharply. So, the building blocks of a turnaround in housing are there but the risk of the market overshooting downwards remains.
The key remaining weapon in the policy armoury is fiscal policy. The gap between the election of Barack Obama in November and the inauguration in January has led to a dearth of new initiatives on spending or taxes. However, it is clear that the incoming administration is planning a massive stimulus which will be enacted shortly after President Obama takes office. This is likely to coincide with the second half of the $700bn Troubled Asset Relief Programme to help the banking sector.
The first quarter of the year in market terms is likely to see a contest between very poor news from the economy and a massive fiscal and monetary stimulus. The current market assumption is putting more emphasis on the negative factors driving the need for the stimulus than the potential upside if it succeeds in restoring confidence.
JAPAN
The Japanese market has recently been the best-performing major equity market, owing to the strength of the yen, which has more than offset worse than average falls in the local indices. The yen strength will benefit domestic growth, reduce import costs and improve consumers' purchasing power and company margins. The collapse in oil prices will also benefit a country low in natural resources.
However, with its two major export markets, the US and China, either in recession or significantly slowing, the strong yen is an unwelcome competitive burden. By adding to the falls in commodity prices it will intensify the swing back into deflation. Although the debt from the 1980s is largely cleared, consumers may (again) defer purchases when prices are falling.
The currency's rise has owed much to the repayment of borrowings associated with speculative investment, as low Japanese rates tempted some investors to borrow in yen to invest in higher yielding securities elsewhere. So, it seems probable that once market sentiment settles and the global outlook becomes clearer the yen will reverse part of its strength, undermining returns for foreign investors.
Domestic policy is relatively powerless to act to counter the renewed recession, as interest rates are already near zero and the public debt ratio still very high. So, Japan appears largely a spectator / passenger of the global recession. Without a sharp fall in the yen the domestic stocks look to have better prospects (a possible exception to the global expectation that large cap stocks will outperform).
FAR EAST AND EMERGING MARKETS
Emerging markets were amongst the worst affected in the equity sell-off in late 2008. As growth forecasts slipped, the risk to emerging economies' prosperity rose and this deterioration was exacerbated by those adopting the common strategy of moving closer to home when times are volatile.
Economic growth forecasts have come down for emerging markets but the growth rates remain significantly higher than the negative levels expected for most developed economies in 2009. So, although they have not "decoupled", prospects appear better than in the past when emerging markets tended to do worse than developed economies. Interest rates have started to fall quickly and fiscal policy is also being eased, to offset the drag from slower exports to the recession-hit Western economies.
Although the timing of a recovery in commodity prices is linked to the turn in the global growth cycle, the falls in late 2008 clearly benefit resource-poor countries in Asia that have embarked on major urban and infrastructure programmes (notably China and India).
In a world environment where growth is scarce the appeal of the faster growth rates available in emerging markets is likely to be sustained. With faster growth available at similar ratings, emerging markets have scope to perform relatively well after 2008's correction.
ALTERNATIVE ASSETS (Incl. Commercial Property)
For most of 2008, "alternative assets" were held back by a common factor: many such investments employ gearing, which magnifies losses from falling asset prices. This is particularly the case when the underlying assets are illiquid (e.g. property or private equity) or when the falls in asset markets are unexpectedly steep, forcing managers to sell assets into unreceptive markets that have already fallen.
Even though commercial yields (rents) now appear high relative to cash, gilts or equities, an overshoot seems to be underway owing to the lack of debt finance available and the possibility of tenant default. Added to this, investors expect distressed sellers to force valuations even lower. It now appears to be the fear of further price overshoots rather than concerns about value that are keeping investors away. This could change if the credit markets start to function, but almost certainly not before.
The alternative asset category most damaged by 2008 appears to be hedge funds. Not only were most of them unable to avoid significant losses (despite their "absolute return" marketing pitch) but many of the funds bought by investors slipped to wide discounts, creating price falls that were in many cases worse than the drops in equity indices. The final nail in the coffin for sentiment was delivered by the disclosure that the Madoff funds may have lost investors up to $50bn. Although it became clear after a few weeks which funds had invested with Madoff and which had not, there was a general sell-off in the sector and it seems likely that significantly improved transparency and better corporate governance will be needed to restore the sector's attraction for investors.
Investors are likely to continue to seek the diversification merits of "alternative" assets, as low cash and bond rates prompt a search for exposure to higher long term returns from real assets in forms that are less correlated with the volatility of equity indices. The learning point from 2008 is that it is vital to understand the underlying investments and pay attention to balance sheet and governance issues.
OUTLOOK
The immediate outlook is for disappointing news on economic growth and corporate earnings. Although media attention will concentrate on the immediate (and usually negative) issues, so many things changed in late 2008 that investors and managers have to be more than usually alert for signs that the present negative trend is changing. Whilst it is possible that the present fragile consensus of a recovery appearing (perhaps still on the horizon) by the end of 2009 will be disappointed, it is also highly likely that the markets will react positively and swiftly before the recovery actually occurs.
With oil prices two thirds below their peak, major shifts in currencies, unprecedented fiscal and monetary easing and massive assistance given to the banks there are more forecasting uncertainties than usual. Many of these changes take time to work through economies, unlike a shock, where the impact is immediate. The assumption that deflation will be around for years and that inflation is effectively dead appears vulnerable. It is only six months ago that central banks were warning about rising inflation expectations and there seems little reason to believe today's received wisdom will be any more accurate than yesterday’s.
Given that the global authorities have embarked upon a deliberate policy of monetary reflation, it would seem reasonable to assume deflation will be short-lived. Also, if any recovery is relatively modest it will be politically hard for governments to remove the current stimulative policies when they have succeeded in averting a depression. As a result, these policies may remain in place for too long, creating higher inflation once the recessionary forces restraining price rises have abated. In that environment, most real assets (equities, property, commodities, and index-linked bonds) would appear more attractive, yet are currently being shunned by investors. By contrast, the currently-prized safe havens of government bonds and cash would see their value eroded, even if the rise in inflation is modest.
Until some level of normality returns, investors need to strike a balance between secure assets that are resistant to nervous sentiment and gaining exposure to a recovery in global confidence. The outlook for economic growth is certainly cloudy, suggesting that it is too early to significantly increase exposure to equities. Commercial Property also appears to still be vulnerable for the foreseeable future. Investment grade corporate bonds are currently offering equity type returns with less risk but, as in all asset categories, paying attention to the quality of the issuer and balance sheet resilience will be important for the foreseeable future. A diversified portfolio, perhaps with a cautious flavour for the first half of 2009, looks like a reasonable way forward.
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