So where do we go from here?

Two months ago the headlines were dominated by the high oil price and fears that stagflation was making a very unwelcome return. At the time we predicted that the US dollar would soon turn and that this would herald a period of correction in commodity prices. In the event this is pretty much what has happened. The US dollar has risen 7% against the euro and 9% against the sterling; the oil price has dropped around 20% and inflationary expectations (as measured by the inflation-linked bond markets) have improved considerably. In light of these helpful developments, the performance of global equities has been disappointing. The MSCI World Index has barely risen and some markets have continued to fall. This lacklustre performance is in part due to falls in energy and basic material shares, itself a logical consequence of lower commodity prices. However, there is clearly more to it than that.

The bearish case for equities rests with the ongoing credit crunch and signs that the American slowdown is spreading to the broader global economy. Following a brief period of relief, credit spreads are widening again, with many of the weaker players now paying more for their debt today than they were back in March. The economic news in Europe and Britain has deteriorated noticeably and the reluctance of the European Central Bank and MPC to cut rates (due to lingering inflation fears) merely serves to deepen the gloom. The property bubbles in many parts of Europe were much bigger than that in America and prices could fall a long way before equilibrium is restored. The economic picture is brighter in America, but this is partly due to one-off tax rebates whose positive impact is already fading.

There are other negatives to consider. The recent equity market recovery, such as it is, has been accompanied by very poor breadth and declining volumes. This is not a good sign. It is also slightly disconcerting that we are entering the September/October period that has traditionally been the worst part of the calendar for the stock market. History also shows that a Republican incumbent losing (still the most likely outcome) is the worst outcome for the stock market in an election year.

But before we get too negative, we must acknowledge the positives that are out there as well. The big drop in the oil price and consequent drop in inflation will shore up consumer spending power and in time will afford the monetary authorities more room to cut interest rates. Sovereign Wealth Funds are carrying out an important function, supplying much-needed capital to the ailing financial sector. Governments are recognising the role they must play in terms of using public money to prop up their economies and to prevent a total unravelling of the financial system. Hugh Peyman, our China consultant in Shanghai, is telling us that the economy is heading for a ‘soft landing’ and that the local stock market could rally 20-30% before the Chinese New Year, albeit off very depressed levels. It is also interesting to note that Japanese companies are investing abroad for the first time since the late 1980s. Finally, even if economic conditions continue to deteriorate, it is important to remember that equities will bottom 6-9 months ahead of the real economy.

So where do we go from here? We foresee two possible scenarios. In the first, America and China slowly lead the global economy out of its current malaise. In the second, the deteriorating situation in Europe and elsewhere leads to a big return of deflationary fears, culminating in a coordinated global reflation effort, involving cuts in interest rates and injections of public money. In the first scenario share prices move hesitantly higher from current levels and in the second, a retest of the lows is followed by a sharp recovery. At this stage, we attach a slightly higher probability to the first outcome, but only just. Key to that view is the fact that investor sentiment remains pretty depressed (note that the last bear market rally only petered out when investors became pretty optimistic). In recognition of the risks and uncertainties we have reduced our exposure to equities (Asset Management has 28% in equities against a maximum permitted level of 50%). If sentiment were to bubble up again (as per May) we may reduce it further.