Our year end targets for the S&P 500 and the FTSE 100 were 1525 and 6550 respectively, levels that were passed on the way up - and on the way down - at least half a dozen times this year.
2007 has been difficult and, as it ends, there is a sense of the dreary and downbeat about the prospects for 2008. That may be no bad thing! It probably means the year will end on an upbeat, though not if profitability continues to slow and analysts continue to downgrade their earnings estimates and, importantly, not if central banks are limited in the extent to which they can bring down interest rates because they feel challenged by rising inflation.
But bring down interest rates they will. Right now, the pressure on headline inflation is coming from food and energy, not demand. The latter, as the chart for the US shows, is slowing and this, in so far as the influence on core inflation is concerned, is likely to prove disinflationary.
We are not convinced a US recession is on the cards for 2008 but the bad news is that the risks to growth are on the downside and that is why we think interest rates will still come down. The rise in headline inflation is squeezing real wage growth and this, plus the slowdown in job growth, will slow the growth of disposable incomes and, in turn, the growth of consumer spending. That underlying trend in the chart will remain downward.
As demand growth continues to slow, the growth of profitability will continue to slow too, meaning the risk is of more earnings downgrades, less job creation, even slower personal income growth and spending and so on and so forth.
All this keeps up default risk, which is another reason for expecting lower interest rates. Who would lend with default risk on the rise? Opportunists maybe, like sovereign wealth funds, but the banks wouldn’t. They would still hoard cash whether or not they had SIVs to bail out.
So the good news is that, given its policy mandate of achieving sustainable non-inflationary growth, the Fed has little choice but to cut rates, which is what it has been doing.
Our view is that the Fed will end up cutting the Funds rate to 3.5 percent by next summer. In the UK, where core inflation is actually falling, the MPC is likely to bring base rates down to 4.75 percent by then. That is also when the trough of the current downswing in the earnings cycle is likely to have been reached and when the downgrading of corporate earnings estimates is likely to have run its course. At that point attention is likely to focus on the prospect of an upswing in the cycle and a more promising outlook for corporate earnings. With much lower interest rates and favourable valuations, the stage should be set for equity markets to resume their upward journey.
Between now and mid-2008, we think the major equity markets will trade as they have been doing these past six months, namely sideways, with poor earnings momentum limiting their upside and lower interest rates limiting their downside.
I view this consolidation phase, following four years of a bull market, as the transition phase to the next stage of the bull market. I expect the S&P 500 to reach to new all time highs and to end 2008 somewhere around 1650. If Wall Street goes my way later next year, then I think the FTSE 100, whose large international blue chips have more to do with the prospects for the global economy than the UK, could be up around 7200 by year-end 2008.
Merry Christmas and happy New Year.