Last year was a ‘once in a lifetime’ year. The developed world economy fell into recession in the second half of 2008 for the first time since the Second World War. As a result, all risk assets had one of their worst years on record. There has also been a dramatic change to inflation expectations.
In the middle of 2008, we were worried about inflation, sparked by rapidly rising commodity prices. But investors are now concerned about deflation, as commodity prices retreat and economies fall into recession.
As a result, bond markets have had a very strong year. The ’credit crisis’ remained with us all through 2008 and it is disappointing that the money markets, although improving, remain dysfunctional at year end.
All asset classes were taken by surprise by the speed and the extent of the economic slowdown in the latter part of the year. The money markets, which went into disarray in the last quarter of 2007, have continued to deteriorate and this eventually had its impact on real economies, as we migrated from Wall Street to Main Street. Consumer sentiment dropped rapidly along with industrial production and employment levels.
In the space of a few months, we have seen a number of economic indicators fall to levels we normally see at the trough of recessions and we are likely to see some further bad news in the near future.
h4. Economics poor and getting worse
Of course, the deterioration in the economic background has led to significant policy response. Just as the recession is unfolding as one of the worst we have seen, so the policy response has been the most extreme we have seen.
Interest rates are now at post-World War II lows and governments across the world are targeting large budget deficits to allow for significant fiscal boosts.
While the international banking system is still stressed, authorities across the world have taken the unusual step of directly investing in their respective banks and in the case of the US, the Central Bank has started lending directly to the private sector. It is probable that we will see more of this during 2009.
A key difference that emerged in the last quarter of 2008 was that policy responses were co-ordinated across the globe. Interest-rate cuts were implemented in several regions at the same time and governments have been intervening in their banking markets simultaneously. This is a big change from the first half of the year, when more Central Banks increased interest rates than cut them.
Authorities have now woken up to the fact that this is a global problem and all are singing off the same hymn sheet.
In the middle of 2008, the European Central Bank (ECB) and the Bank of England were still talking about inflation pressures and thus increasing interest rates. This has now changed and both Central Banks have since cut interest rates by significant amounts and we believe that they will cut further. We now forecast that both the ECB and the Bank of England will cut rates to one per cent by the middle of 2010.
Added to these policy boosts has been the fall in commodity prices, which will also aid consumers’ and corporates’ spending power going through 2009. While these developments have had little impact thus far, we should see some response to them as we travel through the year.
They may not turn economies around, but there is a good chance they will halt the deterioration. As the US economy was the first to experience difficulties (its housing downturn started in 2005), we expect it to be the first to experience improvement. Not only is chronology in its favour, but the authorities have been much more aggressive in monetary policy (interest rates at 0.25 per cent and the Fed lending directly to the corporate sector) and fiscal policy (another package coming in Q1 2009).
The US consumer is also more geared to the oil price and thus, the recent falls will give them a proportionally larger boost. We expect this to also underpin the US dollar and would expect further strength over the next year.
h4. At least bonds like it…
Economic developments have been good news for the bond market. We expect that headline inflation will turn into negative territory in 2009 as commodity price declines impact. We also believe that core inflation will head towards zero per cent.
In the recession in the early 2000s, core inflation in the Eurozone went as low as 0.7 per cent and it should go lower in this recession.
With this inflation background, 10-year bond yields should be able to move below three per cent and in times of a real deflation scare, to go below 2.5 per cent.
In the last recession, the ECB cut rates to two per cent and the 10-year bond yield fell to three per cent. If, as expected, the ECB cuts rates to one per cent, then we believe that the 10-year yield can move to 2.5 per cent.
h4. But not equities
The weakening economic background has taken its toll on equity markets, with ratings dropping to the lowest levels we have seen since the early 1980s. With inflation, interest rates and bond yields at or forecast to fall to 50-year lows, that leaves scope for a re-rating.
Post recent falls, equities now yield more than 10-year bonds across the major markets, a phenomenon we have not seen since the 1950s as the world was recovering from the horror of World War 2 and was entering the fear of the Cold War and the nuclear arms race. The private equity (PE) is lower than at the start of the last two recessions. So, while we may be looking at a more severe recession equity, markets are attempting to price this in.
Currently, the Eurozone equity market trades on a PE of 7.8x, exactly half the 20-year average. So if we are to get back to the 20-year average, earnings need to fall 50 per cent. In the last four recessions, profits fell by an average of 38 per cent peak to trough with a range of 31-41 per cent. One would expect the declines on this occasion to be larger than average due to the lack of inflation and the potential impact of the higher than normal level of debt in the world economy. However, there is a reasonable margin of error built into the current valuation.
h4. Retrenchment
This recession started with a rolling over in property markets which led to strains in the financial system and then moved on to consumer retrenchment and then recession. This is similar to what happened in several countries including the US, the UK, Finland and Sweden in the late 1980s and early 1990s.
Outside of the US, these recessions tended to last longer and the smaller the economy, the deeper the recession. In the US and UK, the equity markets hit their low in Q4 1990, just as the recession was arriving.
The UK remained in recession until Q4 1992, but still the equity market hit its low as the recession arrived.
In the Scandinavian economies, where debt levels were higher and construction made up a bigger proportion of the economy, the equity markets did not bottom until the economy was beginning to recover. We think this time round that the US will behave something like it did in the early 1990s, but Ireland and the UK will be more like Scandinavia.
The one difference for the UK and Ireland today is that Sweden and Finland faced rising interest rates in the early 1990s, whereas Ireland and the UK will face falling interest rates. Thus, the turn in their equity markets might come sooner.
* This articlehas been approved by Goodbody Stockbrokers. While the information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed.
All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
About Gary Culliton
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