Summary
- Hedge fund liquidations and a deteriorating global economic outlook drive equities to new lows.
- Gilt prices rise as inflation peaks, but corporate bond prices fall sharply again.
- UK, European and Japanese equity valuations now match the levels seen at previous turning points.
- Government policy highly supportive of markets but price momentum has yet to turn up for a buy signal.
Equities & Commodities Fall Further
Following the rescue of the global banking system in
September, October offered only an intensification of market
volatility as hedge funds faced large scale redemptions and
were forced to sell equities into a falling market. The result
was heavy losses for all equity markets and a continuation of
the precipitous fall in commodities, with the AIG index down
a further 21% in October. Currency moves were equally
extreme. Capital flowed to the safety of the US dollar and
the Japanese yen was bought by investors looking to repay
borrowings in yen that were becoming increasingly costly as
the currency spiralled upwards. The yen appreciated against
sterling by a staggering 20% in October, making for a 51%
appreciation over 12 months. This currency move offset the
fall in Japanese equities, making Japan the best performing
equity market over the month for a sterling investor.
The global economic news deteriorated at an alarming rate
in October. In the US, the rate of job losses accelerated and
consumer confidence hit its lowest level since records began
in 1967. Not surprisingly, US retail sales were the weakest
for three decades and manufacturing confidence is now at
the lowest level since 1982. In the UK, the picture is similar. Unemployment increased by 0.5% to 5.7%, the biggest rise
since 1991 and a CBI survey showed business confidence at
its weakest since 1980. Perhaps the most telling data is from
the car industry. General Motors of the US announced a 45%
fall in car sales in October compared to the prior year and in
the UK car sales were down 23% year on year. Most striking,
though, was the decline in sales of Volvo trucks in Europe
from 42,000 in October 2007 to just 115 last month. With
this background, it is not surprising that the International
Monetary Fund has reduced forecasts for economic growth
next year to -0.3% for the US, -0.5% for the Eurozone and
-1.3% for the UK.
Inflation to Fall - Positive for Gilts
Although UK inflation was reported at 5.2% for September,
the trend from here should be down. The Bank of England
belatedly recognised this with an unexpectedly large 1.5%
cut in interest rates, which has succeeded in bringing down
interbank lending rates from 6.0% recently to 4.4% at the
time of writing. Yields on gilts have also fallen since the
end of October as expectations for lower inflation haveout-weighed concerns that the government will have to
borrow substantially more to support the economy over
the coming year. Corporate bonds, on the other hand,
have not shared in the rise in gilt prices. Forced sales
by hedge funds and concerns that company defaults will
rise have pushed corporate bond yields to a level above
gilts that was last seen in the 1930’s. This represents
an attractive opportunity to buy high quality corporate
bonds at yields of between 6.0% and 7.5% for maturities
of less than 10 years. The graph below shows how sharply
prices of corporate bonds have fallen relative to gilts over the past month. We look to take advantage of this move
in the coming weeks.
Where Now for Equities?
The speed and extent of the downturn in the global
economy points to a sharp contraction in company
earnings in the coming year, perhaps by as much as 30%,
representing a slowdown worse than that seen in the early
1990’s. UK, European and Japanese stock markets already
discount a decline in earnings of this magnitude. Within
each market, however, different industry sectors are at
varying stages of recognising the threat to earnings. In
the UK, forecasts for retail and housebuilding companies,
for example, already assume a substantial fall in earnings,
which explains why their share prices have been relatively
resilient over the past month.
Historically, the low point in stock markets has coincided
with valuation levels similar to those seen at the end of
October, when the cash flow yield for the UK hit 9.5%,
almost double the long term average. It is not unusual for
the stock market to rise, even though company earnings are still falling, as investors look ahead to economic
recovery. Even though the point of recovery may appear
distant, the policy actions being taken are increasingly
supportive of the global economy and markets. The UK
and Europe have considerable scope to cut interest rates
further and it is likely that UK rates will fall to 2.0% by
mid 2009. This should also promote a weaker sterling,
helping UK exporters. As the chart below shows, the
recent fall in sterling has only taken it back to the long
term equilibrium level against the dollar. There is plenty
of scope for further depreciation.
Governments around the world are also embracing
fiscal stimulus, borrowing to support strategic industries
(banking, insurance, autos) and cutting taxes to help the
consumer. There may be unwanted consequences in the
future of creating higher levels of government indebtedness,
but in the short term this massive intervention should
succeed in underpinning the global economy.
With equity valuations attractive and government policy
supportive, we only need to see price momentum turn up
for all the indicators of a new bull market to be in place.
This has yet to happen, but we are watching closely and
beginning to increase equity exposure in those sectors
that are particularly distressed.
Matthew Hunt
22 Rathbone Street, London W1T 1LA
T: +44 (0)20 7413 2799 F: +44 (0)20 7413 0988
www.prospectwealth.co.uk
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