Our Experts View Of The Markets
Economic and Market Review – For the Quarter Ending December 2007
Supplied by
Brewin Dolphin Stockbrokers
Following a volatile summer, world equity markets came under further
selling pressure during the final quarter of the year as concerns over
banking losses continued to dominate sentiment. Global economic growth
forecasts have been downgraded for 2008 and there is a growing belief
that the US Federal Reserve will be forced to lower interest rates
further, following three cuts since September, in order to relieve the
pressure on banks and ensure that the US economy will avoid falling into
recession. At present, the global economy is expected to grow by 4.8%
next year, according to both the World Bank and the International
Monetary Fund, but these forecasts have been downgraded and could be
pared back further. On the one hand, global growth is decelerating due
to tighter credit conditions but on the other, inflationary pressures
still persist following the surge in crude oil prices throughout 2007.
Prices have almost doubled since January and came close to $100 per
barrel in November. December saw some respite as oil prices fell back to
around $90 but the effect has already fed through into higher food and
energy prices, both of which result in lower personal real incomes. The
FOMC next meets at the end of January and, if the economic and corporate
news flow disappoints, the Fed will have to pull out all the stops and
cut the funds rate by at least 50 basis points. Our view is that the Fed
will cut rates to 3.5% by next summer. Inflationary pressures may be
challenging but, if central banks don’t respond quickly enough, this
could easily pave the way for a far more serious challenge – deflation.
Relative to bond markets, equity markets offer good long term value, as
measured by the bond/equity earnings yield ratio, which is now back to
the level reached at the bottom of the bear market in March 2003.
However, between now and mid-2008, we think the major equity markets
will trade as they have been doing over the past six months, namely
sideways, with poor earnings momentum limiting their upside and lower
interest rates limiting their downside.
Bonds
Government bond markets have benefited from increased volatility in equity markets. Further bad news relating to subprime losses, such as Merrill Lynch’s $8bn write-down, weighed on sentiment and saw government bonds rally from mid-October into overbought territory.
Corporate bond spreads have widened sharply as default risk has increased. The worst casualties have been the financials, where spreads are almost at distress levels, particularly for institutions such as Northern Rock. Despite announcements of write-downs totalling some $40bn so far and a number of CEO’s being replaced, it is feared that this figure will be significantly higher as more losses are yet to be disclosed.
Ratings agencies Moody’s, Standard & Poor’s and Fitch have downgraded or placed under review more than $100bn of collateralised debt obligations during October alone. In many cases the downgrades took bonds from being AAA rated to high yield status. The price action on financials could be viewed as an indicator of a much greater threat to the real economy, in which case we will probably see further monetary easing. However, the bullish viewpoint is that banks will put their balance sheets in order and there will not be a recession, thus further cuts in interest rates will be limited. Three month sterling money market rates remain high relative to riskless interest rates of the same maturity, despite a quarter point cut in base rates by the Bank of England. There are many problems for bond markets to cope with: balance sheet
indebtness, both corporate and personal, a housing market slump and rising energy costs. There has been no new issuance for many months and liquidity remains very tight. Overall, bond markets are telling us that the risks to growth and inflation are on the downside and we can expect lower interest rates. If this occurs, corporate bond spreads ought to narrow and the yield curve normalise, but this could take some time to materialise.
Equities
US – The Federal Reserve lowered its federal funds rate by 25 basis points to 4.25% on 11th December, the third reduction since September 2007. The accompanying statement highlighted that economic growth is slowing, reflecting an intensification of the housing correction and some softening in business and consumer spending. It also stated that core inflation has improved modestly this year, but elevated energy and commodity prices may put upward pressure on inflation. The Fed also acknowledged that the deterioration in financial market conditions has increased the uncertainty surrounding the outlook for economic growth and inflation. At present, consensus forecasts suggest the US economy will expand by around 2.3% in 2008 and, so long as the Fed’s policy remains assertive to any further deterioration in economic conditions, this growth rate ought to be achievable. As far as the equity market is concerned, earnings growth reported by companies within the S&P500 fell short of expectations during the third quarter and, although we have yet to hear results from the fourth quarter, it is likely that these will come in below expectations too (it is well known that the trend in earnings revisions or surprises tends to persist). Earnings growth is slowing a lot faster than expected and, on past form, could continue to disappoint for several more quarters. This is not good news for investment, jobs, personal income and spending. The trend in employment remains downward, the cost of servicing debt has risen and gasoline prices have surged, all of which point to lower real incomes. The housing market has certainly deteriorated: house prices peaked during 2006 and have since fallen around 5%, according to the Case-Shiller measure. Meanwhile new home sales have almost halved from their peak in July 2005. A weaker housing market means consumers have less ability to raise money based on the value of their homes. The knock-on effect on consumer spending has so far been limited, but a decline in real incomes will undoubtedly have a negative impact on spending.
UK – In the UK, the Bank of England’s decision to lower interest rates by 25 basis points to 5.5% on 6th December was a tough one. The accompanying statement mentioned that ‘conditions in financial markets have deteriorated and a tightening in the supply of credit to households posed downside risks to both output and inflation’. The risks to economic growth are now clearly greater than the risk of higher inflation from rising oil and food prices. A number of retail and leisure companies have warned that they are seeing a slowdown in demand on the high street. The latest British Retail Consortium figures hinted that we could be at the start of a prolonged consumer slowdown. UK consumer confidence has declined while consumer debt is at a record high of £1.4 trillion. The recent interest rate cut may go some way in alleviating borrowers’ pain of repaying debt, but consumers are likely to remain cautious as they see the values of their homes fall. The housing market downturn has only just begun. So far, the Halifax has reported three consecutive monthly declines in house prices (Sep, Oct and Nov) but the downturn is likely to extend well into 2008 and possibly beyond. Mortgage approvals are 30% below the peak seen a year ago and new buyer enquiries are down. The next few months are crucial in determining the extent of the slowdown. Certainly, the Bank of England’s recent interest rate cut ought to bolster sentiment: some lenders have already passed on the reduction to customers with variable rate mortgages, despite three month interbank lending rates responding very little to the cut. UK equities have taken their lead from Wall Street and indices are down over the quarter. The large capitalisation stocks held up better than the mid caps, which in turn performed better than the small caps. Interest rate sensitive sectors have been hardest hit and are discounting plenty of bad news. If interest rates fall further, which we expect them to do, the financials could see a re-rating.
EUROPE - Economic confidence in the Eurozone has fallen from highs earlier in the year to its lowest level since early 2006, indicating that sentiment is weakening. European banks, in particular UBS, have been hit by write-downs in subprime loans and the credit crunch that has been hitting institutions globally has not escaped Europe. On 18th December the European Central Bank injected an unprecedented €349bn into the banking system in order to stabilise money markets ahead of the year end, which is traditionally a period of scarce liquidity as market activity is subdued. Inflation in November hit its highest level since 2001, with an annual rate of 3.1%. Because of this, interest rates have been kept at a six year high of 4% but the ECB is at risk of falling behind the curve on monetary policy. So far there is little indication that the ECB is willing to follow the British and American central banks in lowering interest rates, but there is a real risk that a delay in easing could put the economy in danger of falling into recession. We believe the ECB will be forced to lower rates by a total of 75 basis points next year. Tighter credit conditions are beginning to hurt growth in the region. Consumer confidence is now reversing its trend of growth and is falling to levels witnessed a year ago. This is happening against a backdrop of falling unemployment, especially in Germany and France. Economic growth for the region as a whole is expected to be around 2% next year. As for European equity markets, all the headline European indices were down over the quarter. Price/earnings multiples are below 15 year historic averages and, for the DJ Euro Stoxx index, the p/e ratio for next year is forecast to be around 12x. As always, the fate of European equities depends on the performance of Wall Street.
JAPAN – The Bank of Japan’s Tankan survey of business sentiment in December painted a bleak picture for the world’s second largest economy, alongside other negative economic news already in the market. Big manufacturers’ sentiment is at a two year low, GDP growth estimates have been pared back, from initial estimates of 2.6% to current levels of 1.5%, and Japanese firms, currently expecting a rise of only 1.1% in earnings, are struggling to pass on the increase in input prices (in particular oil) to consumers. After struggling for a decade with deflation, inflation remains historically low at around 0.5%, but this offers little support to the companies that are struggling to pass on higher input prices. Chances of an interest rate rise coming from the BoJ seem highly unlikely for the foreseeable future, and this should allow for the large companies who plan to increase their capital expenditure in the short term to do so cheaply. The rapidly decelerating demand for exports from a slowing US economy will hurt demand for Japanese exports: this is key for a number of large manufacturers and service companies that rely heavily on the US for a significant portion of their revenue. This fall in demand, coupled with the yen’s 10% gain over the last six months against a rapidly devaluing US dollar, has created a nightmare for the large exporters in Japan, eroding much of their profit. As for the equity market, the Nikkei and Topix are both down around 10% since the beginning of the fourth quarter. The Nikkei is currently trading on its lowest p/e ratio since 2005 and the Topix is trading on a similarly low level.
ASIA – The key themes throughout the year, namely the Chinese stock market bubble, US subprime and the credit crunch, continued to dominate the markets in Asia ex Japan during the fourth quarter. As well as uncertainty over the US economy another theme took on greater importance during the quarter, the rate of China’s economic growth. There is growing commentary that China’s economy could be entering a mid-cycle slowdown driven by a moderation in infrastructure investments, as third quarter economic growth fell from 11.9% in the April-June period to 11.5% and industrial production data appears to be waning. This led to a mixed performance amongst the region’s markets, with the Taiwanese and Chinese composites experiencing 10-12% falls over the past three months and others such as the Indonesian Jakarta and the Indian SENSEX recording 20-24% gains, the latter in fact breached 20,000 for the first time. The weakening US dollar, record high oil and strong commodity prices are being felt through the Asia ex Japan region as inflation levels and foreign reserves continue to rise. To counter this, further monetary tightening is expected, in doing so taking some steam out of the region’s growth, albeit still well above the global average. Overall, it has been an impressive year for the region’s markets with the biggest gainers being the markets in China such as the Shanghai 300 up 160% and the Hang Seng China Enterprise in Hong Kong recording a 71% increase during the year. Economic growth has also been robust and driven by the region’s two fastest growing economies; with China experiencing its fifth year of double digit growth and India which continues to experience its strongest period of growth since the partition. However, if things do not improve in the US and negative investor sentiment persists, the outlook in the near term will be hindered by caution and global headwinds. This was highlighted by the People’s Bank of China’s governor Zhou, who has expressed concern that the subprime crisis in the US may hurt consumer confidence and slow exports, but he stressed ‘not significantly’. Macro tightening is expected to continue in the region as the central banks try to stem stock market growth and rising inflation levels. On the whole this could see economic growth in the region slow marginally going into 2008.
