Review
After a promising start to the year, nervousness has entered the markets and there are signs that the much awaited slowdown is starting to happen. Equity markets in recent weeks have started to exhibit volatility and the key concern seems to be increasing delinquencies in the US sub-prime mortgage market (borrowers with low credit scores). Such an increase results in a larger number of unsold homes and affects the general housing market. The market is particularly sensitive at present due to the high number of new and existing homes that are currently for sale.
While this news has not come completely unexpectedly, it has been enough to cause falls in US equity prices in recent weeks and unsettle a number of global markets. The Fed has left rates at 5.25% but the statement issued was more bearish than anticipated. That said, there was a hint that rates could be reduced in the not-too-distant future. Recent corrections in Asian markets have largely been a measure to bring back into line over-inflated prices. A moderate cooling off was necessary to prevent the markets from completely overheating. In the last few days, Asian markets have been mixed but some comfort was obtained for Asian exporters from a brief upturn in US housing stats providing comfort that a property slump would not derail expansion of the world’s largest economy.
Key considerations for the remainder of 2007
- Average earnings growth in the UK remains relatively low, but some members of the Bank of England’s Monetary Policy Committee (“MPC”) still believe that interest rates need to be higher to slow economic growth. The MPC will therefore have to carry out a balancing act over coming months. Currently, members of the MPC have voted 8-1 to keep rates on hold but a quick reversal of this policy is always a possibility. Wage data are erratic in the UK and tend to spike via bonuses in the financial sector concentrated in London. This has more of an impact on the London housing market than consumer price inflation in general. Average earnings growth is currently 4.2% (or 3.6% excluding bonuses) but the Bank of England believes the rate should be 4.5% to be consistent with the inflation target for consumer prices. Sterling also appears to be over valued and is likely to fall if it becomes clear that the MPC has finished increasing interest rates.
- In the US, falling house prices could lead to cutbacks in consumer spending and, depending on the level of output growth, the Federal Reserve could make a move to reduce interest rates. A number of US investment banks have suggested there is little chance of problems spreading to other areas of the financial system but the market is generally quite nervous at present and there are signs that retail sales are slowing slightly. US economic activity is likely to remain below trend (2% compared to 3%) for the remainder of the year. Good news can still be found in the market such as a fall in the current account deficit. Despite this fall, the deficit remains huge and has the potential to drag the dollar lower. There are suggestions that it will fall more against Asian currencies.
- Bond Market returns look to be moderate as yields have already discounted an economic slowdown. Any increase in interest rates from the Bank of Japan would particularly hamper Japanese bonds. Corporate bonds are likely to continue to struggle as yield spreads are still at historically low levels.
- Global growth is expected to slow but strong emerging market growth should ensure that globally growth remains at a reasonable level. Domestic spending in Japan and Europe should be able to decouple itself from any slowing elsewhere. ECB President Trichet has said that potential growth in the EMU is around 2.25%, which is higher than expected. The ECB has predicted growth at 2.5%. If this materializes, it would provide justification for the interest rate rises that are generally expected. Equally, Trichet has also said that he feels current rates are 'moderate rather than low and monetary policy was still on the accommodative side' this supports the idea that rates rises are likely but that a peak is near.
- Oil prices should remain broadly where they currently are, helping to control inflation. Equity markets still offer reasonable value if inflation remains stable and should make progress in the medium term if the slowdown is moderate. Volatility will be a feature of markets adjusting to a lower return environment but opportunities still prevail and all eyes will remain on the American housing market. Gold price moved in tandem with the oil market, with precious metal rising to $666.4 per troy ounce. Copper prices nudged toward another new high for the year as a supply deficit is expected in the second quarter, which is the peak demand period of the year for the metal.
At historic high levels, equity markets are hyper-sensitive to even small triggers. There are a number of potential factors that would drag the market down. Higher energy prices have put inflation firmly back on central bank radars. Interest rates are on the rise. Deterioration of sub-prime mortgages indicate the weak underlying strength of the economy. Corporate profits are under threat going forward. However, we strongly believe that, "every dark cloud has a silver lining". The likelihood of a significant downturn is limited and has already been priced in for some time. Progress can still be made - provided the slowdown is short lived. An easing of US monetary policy could provide a small boost to markets and slower earnings may not be too much of an issue considering current valuations. Identifying opportunities may become more difficult but that does not mean they do not exist for the skilled asset allocator.
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This commentary should not be seen as a recommendation or solicitation to invest. Anyone considering investing should first seek advice specific and appropriate for their own needs, objectives and risk appetite.
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