Henderson Global Investors: Economic & Market Update (Edition 10 – 16 July 2008)
A terrible first half to 2008
The first half of 2008 was an awful one for financial
markets. Equity values plunged. The Morgan Stanley
Capital International (MSCI) All-Country World index
fell by 14% in local currency terms. All major equity
markets recorded double-digit falls. Bonds fared a
little better but returns were poor. Although 10-year
yields in the United States were little changed during
the first six months of the year, yields rose in Europe,
the UK and Japan.
There were a number of reasons for this terrible
performance.
First, more losses emerged in the financial system as
a result of the collapse of the US sub-prime mortgage
market. The US investment bank Bear Stearns had
to be rescued, in a move orchestrated by the Federal
Reserve, by JP Morgan.
Second, soaring food and oil prices pushed inflation
rates to levels not seen since 1999. In some
countries, this led to an increase in interest rates. In
others, expected interest rate cuts became less
certain.
Third, global economic growth slowed and leading
indicators, such as business and consumer
confidence, suggested that it would weaken further in
the second half of the year. As a result, expectations
of corporate earnings were cut.
Higher oil prices contributed to the deteriorating
growth and inflation outlook. Over the first six months
of the year, the oil price increased by 46%.
Second half of 2008 – not much better so far
The second half of the year has continued in much
the same vein as the first half. The oil price has risen
to new record highs around $145 a barrel, there has
been a scare about the financial health of the US's
two large mortgage agencies – Fannie Mae and
Freddie Mac - and equity markets have already fallen
by 5% or more in the first two weeks of July. The only
good news is that bond markets have been stronger,
with prices rising and yields falling.
It appears that financial markets are now more
worried about the outlook for economic growth in the
second half of the year, and in 2009, than they are
about the short-term outlook for inflation.
Will the rest of 2008 be any better?
It is easy to be pessimistic about the rest of 2008.
It is unlikely that we have yet heard all the bad news
that is to come out of the financial sector. More
losses related to the US housing market are likely to
be reported. Some smaller banks in the United
States could close down. And there may need to be
more action from the Federal Reserve and the
European Central Bank to stabilise matters.
Meanwhile, global inflation, which is already close to
6%, will climb even higher. In the Euro-zone and the
United Kingdom a peak rate close to 5% is expected
in September or October. In the United States
inflation could reach a high point above 6%.
If oil and food prices stop rising, then the inflation
news should improve, gradually, from the fourth
quarter onwards. However, forecasters have been
assuming that oil and food prices will stop increasing
for some time, and there is no sign yet of it
happening. Primarily, this is because demand growth
in emerging economies remains strong and supply is
unable to cope. Only when emerging economies slow
down, which may not be until 2009, will inflation fears
start to ease.
In the meantime, there is a risk that inflation becomes
entrenched. This would happen if workers look for
larger wage settlements to compensate for higher
food and energy prices and businesses grant higher
settlements and pass the costs on in the form of
higher prices. So far, there is no sign that this is
happening, but the longer recorded inflation stays high, the bigger the risk. It is fair to assume that
central banks would respond to larger wage
settlements by raising interest rates, so increasing
the chances of a recession in 2009.
The global economy, and the European economy in
particular, could come close to recession in 2009 in
any case. Leading indicators already point to a period
of very weak output growth. High interest rates, the
strength of the euro, slower overseas demand and
high oil prices are all likely to prove significant
headwinds to growth over the next year or so.
High inflation and weak growth – called stagflation by
some – is the worst combination for equity markets.
However, it is not that unusual. In a normal economic
cycle, inflation lags real economic activity. As a
result, there is usually a phase when output growth
has slowed but inflation is still rising, reflecting an
earlier period of strong output growth. This is the
phase of the cycle that we are in right now.
If this is a normal cycle, inflation pressures will ease
in 2009 and central banks will be able to relax
monetary policy. This should lift some of the pressure
on equity markets.
There may then be scope for equity markets to rise.
One factor that could boost them is valuation. On
standard measures used in financial markets, like the
price/earnings ratio based on analysts' estimates of
where earnings will be in 12-months time, equity
markets already look cheap. The worry is that, while
the economic situation is deteriorating, earnings
estimates will be cut, so markets may not be as
cheap as they seem. However, once the economic picture appears to be improving, earnings estimates
should start to be revised up. In that environment,
valuation should underpin gains in equity prices.
Unfortunately, that is not likely to be until later this
year, and perhaps not until 2009. In the next few
months, worries about inflation, economic growth and
the financial system are likely to dominate. This is not
good news for equities.
Conclusion
Financial markets in the first half of the year were hit
by a 'perfect storm' of bad news: troubles in the
financial system, slowing economic growth,
downgrades to corporate earnings, higher inflation
and the prospect of rising interest rates.
In the next few months, the news flow is unlikely to
improve much, if at all. So financial markets are likely
to remain volatile and there is a risk of new lows for
equity prices.
However, the bear market is already advanced and
equity markets appear cheap. If this is a normal
cycle, inflation fears should ease towards the end of
the year, creating scope for interest rates in Europe
to come down in 2009 and setting the scene for a
revival in economic growth. At some point, equity
markets should recover in anticipation of such an
outcome.
The second half of the year will not be easy for
investors, but it could turn out to be less bad than the
first half.
Tony Dolphin
Director of Economics and Asset Allocation
Henderson Global Investors
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Date of issue: 16 July 2008
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