Unfortunately, this most definitely hasn’t been the case so far in November. In the US, after setting further all time highs in the first half of October, the Dow Jones Industrial Average and the broader S&P500 have, as at the close of business last night, fallen 9.6% and 9.5% respectively. This has driven the Dow to its lowest level since April. The UK markets have fared worse, with the FTSE 100 index tumbling 9.8% since its near seven-year high on 12 October. But by far the worst affected of the major markets has been Japan, with the Nikkei 225 down a massive 15.0% since mid-October at a 16-month low.
So what has been behind this latest sell-off in world equity markets, and what lies in store in the year ahead? In particular can we expect equity markets to recover their recent sharp losses, or are further declines in prospect? Throughout October, the markets had remained nervous about the developments in the subprime mortgage and wider credit markets and their implications for the global economy. However, investors were able to consol themselves that the Federal Reserve would, as it had intimated, do everything in its power to ensure that the US economy avoided recession. In other words it would cut interest rates and cut them aggressively if necessary. At the same time, a strong rebound in non-farm payrolls in September, and the revision of the previously reported 4,000 August fall to a gain of 89,000, appeared to suggest that the economy was not as weak as some commentators had been suggesting. As a result, share prices around the world continued their upward trend, leaving the four-and-a-half year equity bull market intact.
But everything has changed this month. Although the Federal Reserve delivered the widely anticipated follow-up quarter-point interest rate cut on the very last day of October (after the European markets had closed), it disappointed investors by reinstating its earlier concerns about the upside risks to inflation. This was seen as a clear attempt by the Fed to talk down market expectations of further rate reductions. Such fears were then heightened by the release of the meeting minutes, which revealed that the decision to ease policy had been “a close call”. Meanwhile, there has been a near-endless stream of negative newsflow over the last few weeks, both actual and speculative, about the banking system’s exposure to losses in the US subprime mortgage market, and what this ultimately might mean for economic prospects. Instrumental here were announcements of huge write offs at Merrill Lynch and Citigroup. In addition, the oil price has soared to more than $95 a barrel, sparking concerns about inflation or deflation depending on one’s model of how the world operates. As the anxiety has spread, and the banks have become increasingly unwilling to lend to one another, wholesale money market interest rates have rocketed. As a result, the downside risks to the global economy have increased, amplifying concerns about the prospects for corporate earnings. Faced with such conditions, investors have reduced their exposure to risky investments and sought out safe havens.
Share prices and government bond yields duly plunged (the yield on 10-year US Treasuries has fallen to a two-and-a-half year low of 4.02%), whilst the Japanese yen has rebounded as investors unwound so-called carry trades. The upshot has been that the S&P500 now finds itself broadly where it was at the beginning of the year, whilst the FTSE 100 and All Share Indices are actually 2.4% and 3.7% beneath their respective start-year levels.
So are we now embarking upon a new bear phase? Much rests on whether the global economy, or more precisely the US economy, goes into recession. There is certainly a lot of gloom out there, but we continue to believe an outright contraction in economic activity will be avoided. We recognise that consumer confidence has weakened significantly in recent months, but as the chart shows it remains comfortably above the levels that in the past have been associated with sustained absolute falls in consumer demand. At the same time, conditions within the labour market remain firm. True, the pace of job creation has slowed compared with a couple of years ago, but this was only to be expected given that the US economy has been growing at a sub-trend rate (in underlying terms) for 18-months. More importantly, we expect employment growth to continue, thereby supporting personal disposable incomes and consumption. Admittedly, initial claims for unemployment insurance have ticked up recently, but at an average of 330,000 a week they are currently substantially beneath the 400,000 threshold that historically has signalled outright declines in non-farm payrolls. Thus, whilst we expect the growth in personal consumption expenditure to be relatively subdued in the year ahead, it should remain positive. And with consumer demand accounting for more than two-thirds of GDP, overall economic activity should also continue to expand. Meanwhile, we maintain that the Fed’s preoccupation with inflation is misplaced; although interestingly, its latest forecasts show a lower projection for the next two years. Because growth has been sub-trend for an extended period, barring a sudden and inexplicable collapse in the long run sustainable growth rate, it follows that the amount of spare capacity within the economy has increased during this period. Consequently, we expect inflation, which on the Fed’s preferred measure is already within its implicit 1-2% target range, to continue to moderate. As a result, we are looking for the Fed to ease policy again in December and to follow this up with further reductions next year. This will provide a major boost to sentiment.
As far as we are concerned the biggest downside growth risks are in the UK, where sluggish wage growth, high taxation, high petrol prices and high mortgage debt servicing costs are squeezing discretionary purchasing power. Although we don’t think the housing market is about to implode, these factors will be sufficient to constrain economic growth to just 1.7% next year compared with around 3% in 2007. In such an environment, and with underlying inflation down to just 1.5%, we believe the MPC can now safely start to lower interest rates without taking any risks with inflation.
If we are right, this combination of low, but positive economic growth, and falling inflation and interest rates will provide strong support for equities. In addition, thanks to the latest correction, equity market valuations are substantially better than they were a month or so ago. Indeed, relative to bonds, US equities are now better value than they were at the start of the current bull market in March 2003. In fact they are cheaper than at any time since 1975. We recognise that for the first time in three years, the number of corporate earnings disappointments is exceeding the number of upside surprises, but providing economic growth remains positive so too should earnings.
Similarly, in the UK lower gilt yields (yields on 10-year issues have fallen from 5.58% in July to 4.60% currently) and sharply lower share prices have not only driven the dividend yield ratio back into our “fair value” range, they have pushed it down to its lowest level in more than a year. Again, this would count for nothing if the economy really was heading for recession with corporate earnings growth also turning negative. But whilst we are forecasting slower growth, we are not currently expecting a hard landing. Indeed, earnings per share in the UK are still rising at an annual rate of close to 20%, whilst dividends have grown by a healthy-looking 7%.
Granted, the rates of increase will moderate from here, but with inflation and interest rates likely to surprise on the downside, and with the trailing PE on the All Share Index down at a 16-year low of 11.55, we believe there is scope for some modest re-rating. That said, until the full magnitude of the credit crisis is revealed, conditions with global equity markets will remain extremely volatile. Nevertheless, as long as the global economy manages to avoid recession as we anticipate, we expect to see equity markets re-testing their recent highs during the course of the next 12-months.