Summary
December 2008
- Economic news has deteriorated sharply - no region is escaping the downturn.
- The rapid pace of decline is proving a catalyst for radical policy initiatives to promote growth.
- Government bonds are now looking expensive, but corporate bonds remain attractive.
- Equity markets are cheap but awaiting more clarity on the direction of the global economy.
Economic Outlook Deteriorating
The last month has seen a rapid deterioration in the
economic outlook, with all the major geographic regions
suffering. In the US, virtually every indicator points to a sharp
contraction in activity as the turmoil in the credit markets
is now impacting on the wider economy. The rate of job
losses rose in November at the fastest pace in 34 years and
the workweek shrank to just 33 hours, the shortest since
records began in 1964. With lower employment, retail sales
fell sharply and even exports, which until recently were the
one bright spot in the US economy, posted a decline thanks
to weakening demand around the world. Nowhere has been
immune to the collapse in activity. In the UK, the picture is
similar to the US. Industrial output has now fallen by 5%
since the peak in February. To put this in context, output
fell by 7% during the whole of the two year downturn in
1991-93. Not surprisingly, UK unemployment has risen to
1.8 million, the highest for 10 years and retail sales, which
had been quite resilient up until recently, are now turning
down. The Eurozone is officially in recession, with industrial
output down by 5% over the past year and German business
confidence at its lowest since 1993.
Policymakers Respond Vigorously
The pace of economic slowdown since the disastrous
decision to allow Lehman Brothers to go bankrupt in
September is alarming policymakers. The spectre of a
prolonged recession, as Japan suffered in the 1990’s, or even
a 1930’s style depression, has drawn a vigorous response.
US and UK policymakers have taken the view that deflation
must be prevented at all costs. As a result interest rates
were again cut in the past month, to 1% in the US, to 2% in
the UK and to 2.75% in Europe. In addition, the US is starting
to print money to fund programmes to support the state
purchase of mortgages and to guarantee consumer loans.
This drastic action, potentially highly inflationary, shows that
the US Federal Reserve hopes that by acting decisively and
on a massive scale, the downward spiral can be reversed.
This has succeeded in bringing down market interest rates
to 2.1%, which only six weeks ago were at 4.3%. This points
to the banks being increasingly willing to lend to one another
(reasurred, no doubt, by the $300bn bailout of Citibank in November), though the availability of credit to industry
remains highly restricted.
The prospect of lower inflation, if not deflation, has been
positive for government bonds. 10 year UK gilt yields fell
to 3.8% to produce a 6.4% total return over the month.
As the graph below shows, this has left bond valuations
expensive, with the real yield based on the inflation
average for the past 5 years below zero for the first time in 24 years. There is now a risk that when the various
measures to stimulate the global economy start to take
efffect,
government bonds will be vulnerable to renewed
inflation fears. Corporate bonds are less exposed to this
risk as yields remain relatively high (e.g. 6.1% for a 10 year
Tesco bond) and will benefit from economic recovery.
We continue to see this as an area of opportunity and
maintain our exposure to high quality corporate bonds,
whilst reducing our gilt holdings.
Equities Volatile but Range-bound
Equity markets are torn between the risk that the global
recession will be prolonged and the hope that lower
interest rates and government expenditure will restore
gtrowth by the second half of next year. At present,
it is impossible to predict the outcome, though it is
reassuring (from an equity investor’s perspective) that
interest rates have fallen and that government policy in
the US and UK now appears to be erring on the side of
stimulating growth rather than avoiding inflation. Global
equities certainly offer attractive value on a longer term
perspective at current prices, as is shown in the chart
opposite. In addition, expectations for the growth in
company earnings have been revised down to levels from
which recovery has typically been seen in the past. Thus,
much of the bad news for equities should already be
reflected in market prices.
Commodities Approaching a Floor?
Whilst equity markets (both developed and emerging)
are trading some 15% above their lows for this cycle,
commodities have shown little sustained recovery, with
the DJAIG index now 50% below its July high. OPEC are
due to meet this week to discuss cutting oil production
to prevent a further slide in the oil price. The incentive
to bring supply and demand back into balance is high, as
current oil prices are now below the cost of production
in many regions. This may be a catalyst for a rally in
commodities as investors look past the short term
gloom to recovery. Lower commodity prices themselves
represent a huge stimulus to the world economy - the
fall in oil prices so far represents a $200bn benefit to the
US alone, or 1.5% of total US economic output. We are
therefore looking for a suitable opportunity to reinstate
our commodity exposure.
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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