Markets remain volatile but the end is in sight

The rescue of the US mega-insurer AIG and massive injections of liquidity by central banks should ultimately help to stabilise sentiment badly shaken by the failure of Lehman Brothers. In the short term, the troubles of the financial system seem set to continue. Liquidity has been disappearing as risk is being cut back and a self-feeding dynamic is at work. More mergers are likely as banks are forced to consolidate to survive and we are likely to see some smaller firms fail in this tough environment. Banks will horde cash and credit will remain very expensive and less readily available, increasing the downside risks to growth. However US authorities have again shown their willingness to intervene when push comes to shove, sending out the message that they will not allow this to escalate much further. More dramatic measures now seem likely, such as wider support for the banking sector. These should short-circuit market panic, allowing oversold markets to find support.

The global economy is looking weak. Inflation has risen very sharply, resulting in a big reduction in global spending-power, and the credit crunch is a year old. Given the lags involved, now is the time that the initial shock is fully hitting the system.

In twelve months’ time, however, the outlook should be much brighter. Inflation will have fallen back, helped by the fall in commodity prices and the credit crunch should also be easing. A leaner financial system will have stabilised balance sheets, perhaps with some government help, and the cost of funds will be lower than today, helped by a decline in mortgage rates in the US and looser monetary policy across the world.

Markets will remain volatile, but the level of fear in markets is currently at an extreme. For the brave now is the time to begin to selectively raise exposure to better quality assets that are trading at distressed levels.