On that basis alone, a period of remission is due from the constant selling of the past seven weeks. Indeed, a sizeable rebound is due but these things usually require a catalyst to provide the spark. A big drop in the oil price would do the trick. Certainly the demand side of the fundamentals for the oil market is giving. The reporting of second quarter earnings is about to get under way in the US so a few better than expected results would help too.
As the top chart on the next page shows, the FTSE 100 excluding resources has given up more than half of the bull market gain since 2003. The banks have had the most to do with this. The second of the two charts shows that the historic dividend yield for the banks is now higher than it was in the recessions of the early 1980s and early 1990s and even higher than in the recession of the mid-1970s - the worst recession in the industrialized world on record in the post war period.
What matters is the prospective dividend yield. Based on HSBC, Lloyds, Barclays and Standard Chartered, which are paying cash dividends and which account for about 75 percent of the bank sector, we reckon that the prospective dividend yield for the bank sector as a whole is above 8 percent for this year. However, it’s hard to ignore the chart because its message is loud and clear; not only is a recession on the cards but the also the pain is likely to be at least comparable to that incurred in previous recessions.
Recessions typically follow a period of central bank tightening in response to rising inflation. The difference this time round is that the credit crunch is doing the job. Money market rates remain stubbornly well above central bank rates, which have fallen in the US and in the UK, and lending standards among the commercial banks are, if anything, tightening all round.
The bad news for equity markets is that profitability will remain under pressure and analysts will be forced to continue bringing down their earnings estimates. The good news is that inflation could fall almost as quickly as it has risen. For a start, it is not entrenched in a wage-price spiral in the major economies. Because of this, disinflationary pressure is likely to become easily manifest in economies that are both constrained by the availability of finance - the banks aren’t lending - and restrained by demand deficiency induced by the squeeze on real income growth from higher prices for food and energy. Also, the slowing in the developing economies, which is now beginning to happen, should take the heat out of the commodity markets - oil especially. All of this will help to dampen inflation expectations.
Central banks may feel under pressure to raise interest rates but our view is that yields at the short end of the bond markets will begin discounting cuts in interest rates all over again. However, the risk is that the credit crunch continues and that the downswing in the cycle is not brought to an end in the customary way through lower interest rates.
One asset that has performed impressively throughout the credit crunch - which is approaching its first anniversary - has been UK index-linked government stocks. As the chart on the next page shows, index-linked stocks have performed well not just in relative terms but in absolute terms too. They are expensive now in comparison to conventionals as a result.
Stagflation has been a fertile backdrop for index-linked stocks. It is less clear that they would do so well in a recessionary environment, where, if the credit crunch persists, output will contract and disinflation, if not deflation, will prevail. Conventional gilts are the more likely beneficiary in such an environment. Of course the message in the charts may be wrong, but why take the risk? A weighting in government stocks is a hedge against the prospect of a painful recession and Brewin Dolphin’s recommendation on asset allocation is to overweight them relative to the APCIMS Private Investor Indices.
My year-end target of 7200 for the FTSE 100, which I am now taking down, was based on three points. The first was that the write downs from sub-prime would have been nearly exhausted by this summer and that this would have helped flush away much of the bad news associated with the sub-prime fallout. The second was that US and UK interest rates would be very much lower by the summer than they were at the end of last year, thus inducing the expectation of better times ahead for economic growth. The third was that the promise of those better times would lead, in turn, to an upgrading in consensus expectations for earnings and hence a greater sense of conviction in the valuations for equities.
Well, the banks have written off huge sums. Also, interest rates in the US are a lot lower than they were at the start of the year. This is less the case in the UK but they are still lower. In the eurozone they are higher! However, the credit crisis remains and the crunch has become more pernicious than anticipated. In addition, oil prices have risen well beyond our expectation. Inflation is proving to be more persistent than expected as a result, thus squeezing real household incomes and spending. It is also squeezing profitability, thus forcing companies to revise downward their investment intentions and eroding their capacity to create jobs.
Equity markets are reacting to the likelihood of recession. The US economy is verging on recession and, as for the UK, a recession may be under way already. I think interest rates and/or oil prices need to come down before confidence in equity markets returns. Alright, equity markets tend to be discounting mechanisms, but they still need help in seeing across the economic ravine. I’m now looking for the FTSE 100 to end this year at around 6200. I’m sure better times still lie ahead but you wouldn’t know it for all the gloom.