Investment Outlook - Is there a silver lining?

As 2008 gets underway, our thoughts turn to the year ahead and what it may hold for the financial markets. The consensus view is currently pretty negative, with some saying that America is already in recession. The American Association of Individual Investors’ survey is showing the percentage of equity bulls to have fallen towards decade lows. When the consensus becomes this gloomy it can often make sense to take a contrary view. Is this one of those occasions?

Although the logjam in the money markets is a worry, we believe that we can make a case for adopting a contrarian position. Firstly, equities are attractively priced, at least relative to government bond yields. The yield gap between bonds and equities in America has dropped to its lowest level since the early eighties. This means that even if profits were to some under pressure, the equity market would have a firm underpinning from valuations (particularly given that bond yields would fall further in a recession-type outcome). On the other hand, if the economy were to exceed expectations, there is plenty of scope for equity markets to recover.

Secondly, do not underestimate the ability of the central banks to take decisive action at times like this. Some believe that their attempts are doomed to fail, pointing to Japan’s experience in the nineties. But it’s far from clear that history is set to repeat itself. In the nineties the Bank of Japan was slow to respond to the economic downturn – the Federal Reserve is unlikely to make the same mistake. Indeed, if Ben Bernanke were to ‘drop money from helicopters’, bonds would likely be in more immediate trouble than equities. Also, at this time Japanese banks were slow to respond to the bad debt crisis. In free-wheeling America, they are dealing with the problem rather more directly. What’s more, the banks are on the receiving end of huge capital injections.

Thirdly, even if growth does slow sharply and even if central banks are powerless to do anything about it, the West has other potential saviours. The West is an important export market for both Asia and the Middle East and it is not in their interests to see Western economies drop off a cliff. But what can they do? Thanks to their large current account surpluses, both regions have huge currency reserves that could be reallocated away from bonds into equities. The Western banking system appears to be in need of cash and the East (via its Sovereign Wealth Funds) is in a position to provide it. In fact it’s already started to happen; witness the recent stakes bought in Citigroup, UBS and Morgan Stanley. And at these share prices, they look to be getting a pretty good deal.

The Middle East could also help via its dominant role in OPEC. The purpose of OPEC is to regulate supplies to ensure an optimal combination of price and volumes for its member countries. But has it got its sums right with oil at almost $100 per barrel at a time of such economic uncertainty? A global recession would mean the worst of all possible outcomes for OPEC: poor volumes and a much lower price. If OPEC really thought that there was a risk of this, surely they would look to manage the oil price lower in the short-term to ensure an orderly market for their product in the long run.

There is one final way that Asia and the Middle East could help. As a result of their managed currency regimes, these regions (particularly the latter) are grappling with a developing inflation problem. Currency revaluations would help them in this battle and would simultaneously throw the West an economic life-line. Will these regions ‘ride to the rescue’? It’s hard to say, but when there is such a clear meeting of economic interests, it would perhaps be unwise to bet against it.

So there is some scope for optimism, but as always, the market will be the final arbiter. Bank share prices have stopped falling, but they really need to turn higher before the broader market has any chance of breaking higher. In addition, there are weak links that need to be monitored closely. Some property bubbles in Europe are bigger than those in America and are only just starting to unravel; Britain’s debt-fuelled growth cycle is looking rather long in the tooth; and some ex-members of the Soviet Block (e.g. Latvia and Hungary) are looking very similar to Thailand in 1997.

The world is clearly facing a crisis of some magnitude. However, equity valuations look good, investors are in pessimistic mood and the economic outlook may not be as disastrous as many think. We therefore favour equities over bonds. Geographically, Asia remains our favoured equity region for the long haul. However, pricier valuations combined with the developing inflation problem, might just be enough to prevent the region from outperforming in local currency terms in 2008 (although it may still do well in common currency terms if it revalues its currencies).

Key Points

• The world is clearly facing a crisis of some magnitude. However, equity valuations look good and the economic outlook may not be as disastrous as it seems.
• Equities are attractively priced when compared to government bond yields. In the current American market, even if profits were to come under pressure, the equity market would have a firm underpinning from valuations.
• Central banks in America are taking a direct approach dealing with the current economic downturn.
• Thanks to Asia’s and the Middle East’s large current account surpluses, both regions have huge currency reserves that could be reallocated away from bonds into equities.

In Summary

America may be the one to watch in 2008. It has its problems, but a lot of bad news has already been discounted and the Federal Reserve is working hard to get the economy on its feet. Furthermore, Sovereign Wealth Funds will be particularly keen to snap up bargains that side of the Atlantic. Having underperformed for the last five years, Wall Street may finally be due its time in the sun.