The catalyst for the rebound was last week's decision by the US Federal Reserve to keep interest rates on hold. While the market wasn't expecting any change in interest rates, it was the Fed's language that provided the spark. Investors interpreted the Fed's statement as, "if things get ugly in the housing market, we will lower interest rates."
As always, the prospect of lower rates excited the equity market and share prices across the board soared immediately after the Fed's statement. The fact that lower rates will likely be a product of a weaker economy did not deter the bulls. After only a very brief period of contrition, the market's appetite for risk is back.
Although global markets now appear back in bullish mode, and further short term gains are likely, we continue to see considerable volatility ahead. We therefore reiterate our cautious outlook and continue to favour defensive and value oriented companies over growth stocks.
The recent sell off has exposed some value opportunities. Large cap resources stocks continue to be valued on low price earnings ratios. BHP Billiton, Rio Tinto, and Anglo American have all enjoyed a sharp re-rating in recent weeks as concerns over China's appetite for natural resources has subsided.
In our opinion the market remains too sanguine over the outlook for the US economy. Instead of displaying caution over the recent turmoil in the US sub-prime market, investors have instead celebrated the lower interest rates that any housing market fallout may bring.
From a contrarian viewpoint, this is a concern, although we acknowledge that the bullish euphoria may continue for some time yet.
It is important to remember that housing has been the primary driver behind the resurgent US economy in the past few years, both in terms of construction activity and through increased consumer spending. Early signs of weakness in the housing sector are now emerging, and in time this will have a knock on effect for the broader economy.
The housing industry in the US is quite different to that in the UK. Many of the loans made in the US in the boom years of 2004 and 2005 had 'teaser' interest rates for the first couple of years. In other words, interest repayments on the loans were abnormally low in the initial stages of the loan. These adjustable rate mortgage loans or ARM's, reset at higher rates after the first two years.
"The US housing market experienced 400,000 foreclosures last year and estimates are that foreclosures will double in 2007."
We are now witnessing the impact of those initial loans resetting at higher rates and can expect more pain to come, as loans made throughout 2005 reset this year. The US housing market experienced 400,000 foreclosures last year and estimates are that foreclosures will double in 2007.
This will add considerably to the stock of existing homes for sale. Given the slowing pace of home sales, the supply of new homes now stands at around 8 months, the highest since January 1991.
When supply exceeds demand, prices normally adjust to bring the market back to equilibrium, so we expect further falls in US house prices. Of course, this will be detrimental to consumer demand and the economy generally but we believe the Fed will try to avoid this at all costs. Why?
The US economy is heavily dependent on consumption, which accounts for around 70 percent of total economic growth. Over the past few years, rising house prices have buoyed consumer spending in a number of ways.
Mortgage equity withdrawal has helped turn houses into ATM's, whereby gains in housing equity is converted into debt and then consumed. The rapid securitisation of the mortgage market over the past two decades in the US (and here in the UK) has also accelerated this trend.
Additionally, consumers have viewed rising house prices as savings and are therefore not saving out of current income. In fact, the US household saving rate is in negative territory, the first time this has occurred since the Great Depression.
So it's no wonder the Fed is concerned about the housing
market and stands ready to support prices if need be. We believe the Fed's strategy is to support nominal prices over real prices. In other words, house (and stock) prices may find lower interest rates beneficial, however the inflationary impact of lower rates could well damage real asset prices.
Any indication of this scenario playing out will show up in a weaker dollar as foreign investors find US assets less attractive. We believe this trend is already well advanced, and in fact this has been one factor behind the stronger gold price in recent weeks.
The flipside of a weaker US dollar is a loss of purchasing power. The Greenback's value has steadily eroded against all major currencies over the past few years, most significantly against gold. In our view assets such as houses might maintain their nominal dollar price levels, however inflation will erode the real value of such assets.
Partly for this reason, we remain bullish on commodity prices. Real assets such as gold and base metals like copper, zinc and nickel provide a natural hedge against inflation.
Although the rises in the consumer price indices in the US and the UK have been relatively benign in recent years, we believe it only a matter of time before general inflation catches up to the asset inflation witnessed in recent years.
Following the Fed's announcement last week, the US dollar index declined. Currency traders now appear to be marking the dollar down in anticipation of lower interest rates. (The main reason for US dollar strength throughout 2006, even in the face of huge deficits, was the relative attractiveness of US domestic interest rates.)
However the prospect of a US interest rate cut now points to a lower dollar. Asset markets have already responded with commodities such as copper, zinc, oil and gold all roaring back to life over the past week.
We continue to be comfortable in our outlook for financial markets this year. While volatility should remain a feature, we believe lower interest rates should continue to support asset prices.
At the beginning of the year we told our clients that a weaker US housing market would cause interest rates and the dollar to fall. Although we are yet to see interest rates lowered, the currency markets have already responded and we now think it only a matter of time before the Fed acts to avoid recession.
As shown on the daily chart, trendline resistance in the region of 85.40 thwarted the US dollar's attempt to rally from December's low of 82.24. This falling trendline has defined the downtrend in the USD Index for much of the past 16 months.
In the weeks ahead, we anticipate further weakness will see the index retesting 82.24. Failure to hold above here will further weaken the outlook, and target the major low of December 2004 at 80.39 ahead of the record low of 1992 at 78.19.
What's bad for the US dollar is good for gold. With the yellow metal still trading below last May's high of US$730 we continue to see value and opportunity within the sector.
"Gold is in a primary bull market and we firmly believe the precious metal will trade significantly higher in the years ahead."
We believe the environment for gold has never looked better. The Fed appears likely to cut interest rates to support the US housing market, which will in turn undermine the dollar, gold's biggest competitor. The Fed may attempt to create excess fiat currency to cushion the fall in the housing market, but the real beneficiary will be gold.
What does all this mean for UK markets? We are certainly seeing the effect on our currency. The British pound is hovering near 14 year highs against the greenback. The strength of sterling might provide a reason for the Bank of England to keep interest rates on hold. A strong currency helps to keep inflationary pressures in check by lowering the price of imported goods.
However, the Bank also appears concerned with the strength of the domestic economy so another interest rate rise is definitely on the cards. Indeed governor Mervyn King stated this week that with respect to inflation ‘risks are to the upside’.
Data out this week add to the growing case for another rate rise. Whilst mortgage approvals are showing stability, lending secured on property continues to rise, climbing 8 percent to £10.3 billion in February. Resilience in the housing market is turn driving consumer spending strength. Retail sales volumes shot up 4.9 percent in February, the fastest pace in a year and twice the rate predicted by economic forecasters.
And whilst there is certainly a case for the wind to be taken out of the UK property market, a full scale collapse is less likely. While affordability is waning, a shortage of land and migrant demand is likely to ensure we are talking about a ‘correction’ rather than a ‘crash’. Therefore whilst we believe the UK property sector is one to avoid, we do not expect weakness sufficient to send the UK economy into a tailspin, Measured interest rate rises by the Bank should ensure as much.
In any case the differing interest rate deliberations by the US and UK central banks highlight the strength or otherwise of the respective economies.
While the UK economy remains upbeat, we acknowledge that the US remains the world's dominant economy. Any major trouble in the US will have global implications. Given our views, we do not believe stock markets are adequately pricing risk and we therefore maintain our cautious view.
Additionally, we continue to strongly favour stocks in the energy, precious metals and resources sector.
Greg Smith is the Managing Director of Fat Prophets. If you would like a further sample of their expert research please click here.
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