MARKET COMMENTARY by Richard Smith
Recent months have seen the arrival of a sobering, if not pessimistic, outlook settling over both global bond and global equity markets, in the face of decelerating economic growth and accelerating inflation.
Initially, in the second quarter, markets reacted positively to official efforts to stabilise the financial system, in the wake of the Bear Stearns debacle. There was a sharp rally in equity markets and a recovery in corporate bonds, particularly those issued by the banks. Banks set about raising additional capital to make up their losses and equip their balance sheets to resume normal lending, or so it was hoped. This positive interlude came to an end during May, when nervous investors began to decline the banks offers. The realisation that the recapitalisation of the banking sector would take longer than expected, exerting downward pressure on economic growth in the process was a major catalyst in the market about-turn. Money market conditions have still not returned to normal, with interbank lending rates remaining abnormally high. Banks responded to this raised cost of funding by rationing new lending and charging more for it.
The lenders of last resort, the central banks, were unable to react to this by easing monetary conditions further, owing to a sharp rise in inflation. The oil price rose by half in the first 6 months of the year, accelerating between March and June. The coincidence of rising oil costs with higher crop prices forced central banks to disappoint hopes of looser policies owing to the priority given to fighting inflation which has risen well above target levels. With a slowdown underway, driven by a contraction in credit, and rising inflation preventing the authorities from cutting interest rates, there is the fear of a return to the 1970s problem of “stagflation”. Although the downturn in growth is not yet as sharp as in the recessions of that era and inflation rates remain much lower, having to wait while one problem (inflation) is solved until the other (growth) could be addressed is unfamiliar and unwelcome.
Adding to the negative mood is the lack of control held over the main drivers of inflation, largely linked to rising commodity prices. Although developed economies are relatively economical users of commodities, the rise is a by-product of rapid industrialisation in economies such as China and India (directly increasing demand for oil and metals) with their resulting prosperity leading to increased food demand.
Until now, globalisation has been seen as relatively cost free for “western” economies, delivering supplies of ever-cheaper consumer goods, manufactured in emerging economies. Now, the pressure on resources from those countries’ rapid growth appears to have strained the capacity of the world’s mines, wells and fields. For example, of the 12m barrels per day rise in oil use since 2002, 11m barrels of that demand has come from emerging economies. Three quarters of the rise in production has come from OPEC, further increasing their market influence.
The oil price is a particular concern. Oil products have few substitutes in the short term so rises in their cost have to be offset by reduced spending in other areas. The rise in prices has therefore had the double negative effect of reducing spending power for consumers while preventing central banks from doing anything about it owing to the resulting hike in inflation.
EQUITY MARKETS
United Kingdom
The UK domestic economy has slowed significantly but, as above, the Bank of England is unable to offer assistance in the form of lower interest rates, as inflation remains above target levels. The domestic housing market finally ran out of momentum in late 2007 and has been falling since, affected by overextended prices and tightening of credit for new lending. This has made it more expensive for existing borrowers to refinance and reduced loan availability for new buyers. The resulting weakness in the housing market has fed into consumer spending, as the option of home equity withdrawal has all but disappeared, at the same time as consumers have faced soaring food and fuel costs. Although the economy is expected to continue to grow modestly (helped by a weaker pound), a rapid revival appears unlikely until existing consumer debt has been brought down or there is relief on the oil price front. The government’s finances are also stretched, although political pressures appear to be steering the government in the direction of larger deficits. The stock market has been distorted by the weakness of the major banks and outperformance of oils and mining stocks. Looking forward, it seems unlikely the market will make significant progress without a recovery in the sectors sensitive to the domestic economy.
USA
The US economy has continued to slow, while remaining clear of recession (just). Consumer spending is likely to find some support from tax rebates passed earlier in the year, although much of this will be spent on increased energy costs. With unemployment trending upwards, consumers might also adopt a more conservative attitude towards what they spend and save. The key to any adjustment remains the housing market, both for its direct effect on the construction industry and, as in the UK, for its bearing on the overall “feel good” factor for consumers. The indications are that the housing adjustment will be prolonged, with little improvement in 2008, due to a glut of unsold new homes and the tightness of credit availability. So, although forecast estimates for growth suggest this will be a relatively mild downturn, it could also be disappointingly long one. The political climate will heat up further this autumn during the presidential contest with the possibility of significant policy changes. Investors may have to factor in the risk of a less business-friendly and/or a more protectionist government.
Europe
European economies have clearly slowed this year, influenced by slowing global growth, the strength of the Euro and the vulnerability of some economies to the ructions in financial markets. The European Central Bank has stuck to its task in prioritising the control of inflation, despite political pressure to cut interest rates to alleviate the growth pressures. With the additional impulse of the rise in oil prices in the early summer, there is even the possibility of higher rates in the coming months. The ECB is standing firm against the deceptive benefits of stimulating growth when inflation is rising and, hugely uncomfortable as it is for politicians, the experience of the 1970s suggests this approach has merit. With slowing growth, the pressure on resources that lies at the heart of inflation should abate. In the meantime, European companies are likely to be under greater pressure than competitors in countries with more competitive currencies, such as the US and Japan.
Japan
The Japanese economy has weakened in response to slower global growth, although seasonal adjustment of the first quarter growth figures presents a more optimistic picture. Japan has an interesting demographic problem in that domestic demand is being squeezed by weak wage growth as highly paid retirees are replaced with lowly paid younger workers. They too are under pressure from commodity price inflation. Growth is likely to remain weak, on some estimates the economy may already be in recession. On the positive side, Japanese export exposure to, and earnings sourced from, China have both grown and the economy, having been in its own cyclical black hole for the last decade and a half, is out of step with the global cycle. Indeed, it is one of the few regions that would welcome the return of inflation, which would eat away at the burden of public sector debt taken on to combat the years of weak growth as well as the private sector debt problems that led to it. Currency adjusted, Japan has been a good relative performer this year and the market continues to offer diversification benefits relative to credit-crunch-afflicted western markets.
Far East Ex Japan / Emerging Markets
Emerging markets have continued to grow relatively rapidly but the inflationary costs have now become more visible. Although emerging economies have obvious advantages in terms of relative costs, mechanisms for managing peoples’ expectations are often less well advanced. Prosperity being a relatively new phenomenon, the sacrifices that sometimes have to be endured to make growth sustainable - such as enduring economic downturns in order to bring inflation under control - are not always appreciated by the politicians or easily sold to their electors. This has led to a willingness to plough on regardless, building up inflation pressures, both through domestic wage rises and the impact on global commodity prices of demand growing faster than supply.
China, hosting the Olympics this summer, has a clear motivation to finish any related projects and to ensure that shortages are not endured before or during the games. They are also believed to be switching coal fired generation to oil fired ahead of the Games, to reduce pollution levels, which is likely to have put further pressure on oil demand. Aside from this, they have had to cope with a range of natural disasters this year, complicating the authorities’ task in seeking to slow the economy to a sustainable pace. A more tangible slowdown seems possible after the Games have passed, which might usher in a correction in the commodities boom, relieving economic pressures worldwide.
The case for emerging economies remains strong, driven by a faster rate of growth and multiple sources of competitive advantage relative to mature economies. Although a slowdown in economic growth rates appears likely, even desirable, later in the year, this should help lay the platform for a more sustainable expansion in future years.
Bonds
Inflation is now the major focus for central bankers as the likelihood of a financial market implosion under the weight of debt and derivative products seems to be averted, for the moment at least. The desire for low risk assets such as gilts had driven the yields down to historically very low levels although this has quickly reversed
As always, if you have any queries or questions please do not hesitate to contact me .
Richard Smih
0845 226 9106
