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Gazing across the abyss

Friday 18 January 2008 05:48PM

Going into 2008 there is a definite lack of confidence and a growing sense of the unknown as to the direction of markets. Two critical variables, which are interrelated, are the resolution of the credit crisis and global economic growth.  The total disregard for risk and financial responsibility, driven by unbridled greed and ingenious financial engineering over the last several years, has finally tripped up the financial system and exacerbated an already weakening US economy. 

The consensus of economists and strategists is to look across the proverbial valley to greener pastures in the second half of the year which should benefit from lower interest rates and restored liquidity.  However, in the interim, there is the risk of sliding into a significant slowdown unless there is a convincing work-out of the debt problem and the US can avoid a recession.

The full extent of the debt problem remains unknown in that CDOs cannot be perfectly valued.  There is also the contagion effect that could spread to other types of securitised debt.  As regards sub-prime, the Bank Credit Analyst (BCA) notes that banks and brokers have announced write-downs of about USD 100 billion in the second half of 2007. BCA maintains that there is at least another USD 100-200 billion, to be located and realised, which will need to be written off in 2008 by insurance companies, finance companies and hedge funds. 

To equal the savings and loan crisis of the ‘80s and ‘90s, which represented 2.6% of GDP and led to a sharp recession, USD 350 billion would have to be written off.  It is still not certain what amounts banks have yet to write off.  As the full year 2007 results for banks are announced in January and February, further surprises can be expected.  BCA also notes that the deleveraging of the securitised space has yet to be played out. 

Until all the complex mortgage-related structured products can be valued in a way that carries conviction, valuing banks will be a hazardous process.  Trust must be re-established between banks to enable them to continue functioning as lenders to foster economic growth.

Most economists are forecasting a global slowdown in 2008 (4.3% versus 5.1%) with the brunt of it coming in the developed world (1.4% versus 2.4%); whereas in the developing world there will barely be any impact (6.8% versus 7.6%).  4.3% may below the average of 4.9% over the last four years, but is well above the 3.7% average of the previous 45 years.  A recovery is expected in 2009. 

A related concern is what impact such a slowdown will have on corporate earnings? Most analysts are still forecasting growth of at least 10%+ from a bottom up view, but only 3-5% top down.  The first six months of 2008, and especially the first quarter, will be fraught with uncertainty as to the outcome of the credit crisis and the direction of the global economy with a prime focus on the US. 

As risk aversion increases, a great deal of volatility can be expected as the markets lurch back and forth between good and bad news. Should developments unravel less negatively than anticipated, a return to normalcy is envisaged for the second half of the year.  However, it should not be forgotten that in moments of uncertainty great opportunities are created.

The US
Last week’s release of two leading economic indicators on manufacturing and employment were the first clear signs of danger to US economic expansion.  The ISM index dropped in December below the neutral level of 50 to 47.7 and new jobs added were only 18,000, the lowest levels for both since 2003.  Such numbers will undoubtedly lead to a flurry of downward economic forecasts and heighten the odds of a recession. 

In fact, Morgan Stanley (Richard Berner and David Greenlaw) were already forecasting in mid-December the likelihood of a mild recession, with domestic demand contracting by an average of 1% annualised in the first three quarters of 2008.  They expect this to lead to a contraction of 5 10% in earnings.  The three factors that prompted this change were: financial conditions continuing to tighten, domestic economic weakness broadening into capital spending, and global growth slowing. 

Abhijit Chakrabortti (Morgan Stanley’s US Strategist) points out that the median peak-to-trough decline in S&P 500 earnings in recessions over the past 50 years has been 16%.  However, on a more sobering note, he shows that, currently, S&P earnings are 62% above their long term trend.  A fall back to the trendline by the end of 2008 would require a 38% decline in earnings in 2008.  Usually in a recession they have always broken below the trendline.  Thus, many earnings surprises and downgrades can be expected throughout 2008.

The parlous state of the housing market is reflected by the 4.4 million unsold units which, in order to be cleared, would have to see housing starts either fall by 40% or prices fall by 15%.   So far prices are only off by 5-6% since their peak in the summer of 2006.  Housing starts at their peak in 2005 reached 2.2 million and today are running at 1.2 million; Goldman Sachs sees them dropping as low as 750,000 in 2008.

Even more disturbing is that today household debt stands at 136% of disposable income versus only 100% in 2001.  Debt has risen as much in the last six years as in the previous 39 years.  Increasing unemployment and the credit crunch should inevitably start impacting consumer spending, which proved to be sluggish over the Christmas season. 

The darkening clouds of economic weakness will force the Fed to continue cutting rates going forward in 2008 and, as of last Friday, the probability of a 50 basis cut in late January has risen to 50%.  The Fed has become far more preoccupied by the state of the economy and the banking system than by the potential of rising inflation. The most negative strategist, David Rosenberg (Merrill Lynch), sees the Fed Fund rate going as low as 2.5% by the end of 2008.

Europe
Europe, unlike the US and the UK, has not lowered interest rates but rather has been regularly injecting huge amounts of liquidity into the banking system including the latest tranche of €349 billion in mid-December.  The frequency and the size of the injections, which vastly exceed those of the Fed and the Bank of England, raises the suspicion that many hidden problems have still not been addressed in Europe. 

Except for UBS, which is very US centric, there have, as yet, been few write-downs of debt.  Rather, Mr. Trichet continues to be more committed to fighting inflation.  Euro inflation rose to 3.1% in December, which far exceeds the ECB target rate of 2%.  The higher interest rate differential continues to favour the Euro over the US Dollar, but it is beginning to impact exports.  The ECB has just lowered its growth target for 2008 to 2.00% versus 2.6% for this year.  Morgan Stanley even goes lower to 1.6%.  With German investor confidence at a fifteen-year low, the outlook for Europe invites caution.

The prospects for the UK are not much better, with GDP expected to fall to 1.8% growth this year as opposed to 3.00% in 2007.  The areas of greatest economic vulnerability are the finance and business services sectors which account for only 25% of GDP but account for 50% of GDP growth.  Furthermore house prices seem to be topping out.  

However, like Mr. Bernanke, Mr. King has already cut rates once and is likely to do so again in 2008.  This will not be favourable to Sterling, which seems overvalued.  The UK recorded a record current account deficit in Q3, representing 5.7% of GDP.  Thus the currency is expected to remain under some pressure.

 
Japan
The economy continues to disappoint, with Q3 GDP being revised down from a previously announced annual rate of 2.6% to 1.5%.  Capital spending has softened and consumer spending remains weak, down 0.6% in November.  Consumer confidence is showing no signs of picking up and is still at a four-year low.  The latest Tankan survey reported signs of deteriorating business conditions, with business confidence at its lowest level in two years.

The economy remains very fragile and will not be helped by a global slowdown.  Even profitability is being impacted: recurring profits declined by 0.7% in Q3, the first drop in fifteen quarters.  Yet on a valuation basis the market is not expensive. Goldman Sachs believes there is good fundamental support since nearly half of all listed firms are trading below book value.  Global investors remain very much underweight at 15% versus an EAFE weighting of 21%.  Perhaps, when everyone has given up on Japan, there may be an opportunity.   But it could be like waiting for Godot!

Asia ex Japan
All the economies continue to rack up positive growth and the forecasts for 2008 are for a slight dip from 2007 growth of 8.8% to 7.8% this year.  So far the decoupling theory remains in place on the back of reflation driven by consumption and accelerating public and private sector fixed investment.  Hong Kong’s retail sales rose by a staggering 19.5% in November.

The only negative news concerned Singapore, where Q4 GDP dropped at an annual rate of 3.2%.  But this should be put into perspective as, on a year-on-year basis, growth is still up 6.0%.  So far it would appear that Asia may well remain relatively immune from the global economic slowdown and the credit crisis.  However, there is one indicator that bears watching: the Baltic Dry Index, which has dropped a disconcerting 21% since late October to the end of last week.  This has always been a good proxy for Asian exports and growth.

China continues to power ahead despite efforts by the government to slow growth by raising interest rates and increasing reserve requirements.  Growth is expected to slow to 10% this year versus 11.4% in 2007.  The tax rate has been harmonised at 25% lower than the previous average of 33%, which will give a one-off boost to earnings. 

However, the market is no longer cheap and a healthy correction would be welcomed.  This is unlikely as real interest rates remain negative.  China’s development is unprecedented in history.  Lawrence Summers recently pointed out that during the Industrial Revolution the average European’s living standards rose about 50% over the course of his lifetime (then about 40 years).  In Asia, principally China, he calculates, the average person’s living standard are set to rise by 10,000% in a lifetime!

Outlook
Analogies are being drawn comparing the current US banking crisis to that of Japan. There are, however, some major differences.  The US banking system is considerably more transparent.  Furthermore, the sovereign wealth funds are a new source of much-needed funding.  The extent of the damage is still not clear.  More importantly, the work-out time is still an unknown. 

The other risk is contagion spreading throughout the financial system. Cutting interest rates only buys time and relieves pressure.  But it does not resolve the fundamental issue of solvency and the new capital that some banks will have to raise. Furthermore, there may be a limit as to how much the Fed will cut rates as inflation is being exacerbated by the rise in the price of oil, soft commodities and gold.  The threat of stagflation is a remote possibility. 

The key to manoeuvring through the current storm will be to avoid a recession in the US which should allow the rest of the world to keep on growing, especially the developing world which should generate the cash to subsidise the developed world.  According to Morgan Stanley, emerging markets will account for 80 cents out of every $1.00 of global economic growth in 2008.

Conclusion
For 2008 an investment posture of conservatism and caution should be the order of the day.  There will be much greater volatility until there is a clearer picture of what is in store for the global economy, corporate earnings and the ultimate damage to the credit markets.  As a result we are going neutral both in equities and fixed income from a previous overweight and underweight respectively.  Cash remains at a neutral weight. 

We continue to favour large cap well-capitalised companies with a growth bias and visible earnings.  In America we have gone from underweight to neutral, and in Europe and the UK to underweight.  We remain underweight in Japan. We maintain our overweight in Asia and Emerging Markets/Commodities.  In fixed income duration has been reduced with a focus on quality corporates.  On currencies the US Dollar is preferred over Sterling, and the Euro over the US Dollar as we move into 2008.

The essence to the outlook for 2008 is whether equities, which are down from their peaks set last year, are entering a bear market; or merely the final, most volatile, stage of a mature bull market.

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