Wall Street has got off comparatively lightly thus far, but this certainly hasn’t been the case elsewhere. Last night the FTSE-100 index closed at 5942.9, the lowest since just before the US Federal Reserve cut its discount rate in mid-August, whilst in Hong Kong the Hang Seng Index has now fallen more than 20% in the past month alone. Meanwhile, the Japanese Nikkei 225 has fallen 26% since hitting a seven year high as recently as July. What is surprising about the size of the declines in Asia and Japan is that these countries’ direct exposure to the US subprime mortgage market is extremely small. Instead, the main factor in the recent correction has been growing concern about the outlook for the US economy, the main engine of global growth over the past decade.
The deepening crisis in the credit markets and the “implosion” of the US real estate sector have convinced many commentators that a recession is now inevitable in the US in 2008. With the personal savings rate effectively at zero, the concern is that any “negative wealth effects” emanating from falling house prices will result in householders cutting back on spending in an attempt to shore up their balance sheets. We are not convinced. Whilst house prices are indeed falling, this needs to be set in the context of a rise of more than $5,000bn in owners’ equity in real estate since the start of the decade. What’s more, the value of the personal sector’s financial assets are almost twice as large as their tangible assets, which means that total personal sector net worth has soared $15,000bn over the same period. We would therefore argue that the US personal sector is in fact well-placed to withstand a period of falling house prices without having to compensate by saving elsewhere. Meanwhile, the labour market continues to generate new jobs, albeit at a slower pace than in recent years, but sufficient to support disposable incomes. Consequently, and with consumer confidence (see chart) still significantly above the levels that in the past have been associated with outright declines in consumer spending, we expect consumer demand to surprise on the upside for some time to come. Activity will slow in 2008, but growth should still be around 2%.
In such an environment, the Fed’s renewed concerns about inflation are misplaced. True, the price of oil is at a record high, and this has pushed up headline inflation. However, the core measure remains firmly under control, a reflection of the fact that in the presence of excess capacity higher energy prices simply cannot feed through into more generalised inflation. And nor will they as long as growth remains beneath trend in the year ahead. Consequently, there is nothing to stop the Fed from doing whatever is necessary to ensure that economic growth remains positive. The target for the Federal Funds rate could fall by another 75-100 basis points in 2008.
This ought to provide an ideal scenario for the US Treasury bond market. Indeed, despite currently being underpinned by safe-haven buying, we envisage yields being down as low as 3.5% in 12 months’ time. This should further enhance equity market valuations, which are already towards the bottom end of our fair value range. Admittedly, after surprising on the upside almost continuously over the last three years earnings growth is slowing abruptly. However, as interest rates continue to fall, increasingly investors will begin to look ahead to the next cyclical upswing in the economy and profits. Consequently, and with inflation set to decline, we think there is scope for multiple expansions in the year ahead.
In the UK, the outlook for monetary policy has changed dramatically in just a few months, with financial markets already pricing in interest rate cuts totalling 50-75 basis points in 2008. We would concur. Only if growth remained above trend would interest rates remain high. But the signs are that the economy is already shifting down through the gears, with consumers becoming increasingly reluctant to part with their hard-earned cash even when prices are falling. This is hardly surprising given that post tax real disposable incomes are lower than they were a year ago, whilst interest rate increases have resulted in a doubling of mortgage debt servicing costs in four years. Meanwhile, the ongoing turmoil in the credit markets means that activity in the financial services sector, which has accounted for more than half the increase in overall GDP in each of the last two quarters, will now slow abruptly. For these reasons, after more than 3% in 2007, we are looking for economic growth to slow to just 1.6% in 2008.
On this basis, the underlying trend in inflation over the next couple of years will be downward. In the near term, the latest rise in energy prices may keep inflation above target, but as this drops out of the annual inflation we should then see it falling back sharply again. Given this, we are bullish about prospects for the gilt market. Admittedly, yields have fallen significantly already as equity markets sold off, but as interest rates are cut in 2008 they should be significantly lower than they are now in 12 months’ time. We are less optimistic about equities, especially with earnings growth turning down. But even here, providing recession can be avoided and with valuations undemanding some modest progress is achievable in the year ahead.