Review Quarter 3 2007
It had to happen sooner or later. After US interest rates rose from 1% to 5.25% between 2004 and 2006, the number of mortgage delinquencies began to rise significantly - particularly on the part of sub-prime borrowers, millions of whom borrowed more than they could afford on adjustable-rate mortgages (ARMs) with ultra-low teaser (or even zero!) rates for the first few years.
The pigeons spawned by that orgy of irresponsible lending ("Liar Loans"!) are now coming home to roost in droves. According to the American Mortgage Bankers' Association, more than a trillion dollars' worth of ARMs are re-setting in 2007, with more to follow next year. The largest number of re-settings is due to take place at the end of this year and the beginning of next; so it is clear that the repercussions will reverberate around the global economy for some time to come.
The delinquency rate on US sub-prime mortgages is now about 14% and rising. The delinquency rate for ARMs in the prime sector is also rising, but is still below 2%. All this means that there is now a record number of houses on the market as a result of foreclosures on existing properties, and the inability of developers to sell new properties to would-be buyers who can no longer obtain a mortgage.
All this is putting pressure on US consumer spending, which accounts for about two-thirds of US GDP. In addition, the credit markets all but froze - not because there was a shortage of money in the system (on the contrary!), but because lenders lost confidence in each other's credit. Securitised mortgages and their derivatives (worth trillions) are widely used as collateral in the money markets; but, with the value of the collateral falling and the number of delinquencies rising, nobody really knew how much these esoteric instruments were worth, nor who was holding what.
To the rescue, in the best traditions of the US Cavalry, came the US Federal Reserve, the European Central Bank and several others (but not the Bank of England). They injected humongous amounts of cash into the banking system and cut the discount rate, which allowed banks to borrow directly from the central bankers instead of from each other.
Let there be no misunderstanding, however: it's going to take the python more than a few weeks to digest this particular cow.
Turning to the UK, in July the Bank of England raised interest rates by 0.25% to 5.75%. Some have expressed concern that, if inflation rates remain too high for too long, it will become embedded in the system and it needs to be rectified. Japan's economy is contracting at an annual rate of 1.2%. Although quarter 2 results exaggerated the weakness, it is clear that momentum is slowing and political uncertainty following the resignation of the Prime Minister Abe creates uncertainty in financial markets. In China, inflation has risen to 6.5%, largely a result of gains in food prices. This has the potential to create increased wage demands that will boost core inflation and create unnecessary pressures on the economy.
Outlook
US
The 0.5% Fed Funds rate cut on 18th September was a watershed event for the global economy. It represented a fundamental shift in Fed tactics from reacting to data to trying to "get out ahead of the situation and try to forestall" a recession. The Fed's economic models clearly see trouble ahead and are telling officials to act early and act aggressively. The Fed wants to cut rates far enough and fast enough so that mortgages become affordable again and, hopefully, reduce the damage to the wider economy which an imploding housing market would otherwise inflict. The FOMC has clearly taken the view that the risk to the financial system as a whole is greater than the moral hazards of bailing out the mortgage markets. Whether rate cuts will be enough to avoid an implosion of the mortgage derivatives markets or not remains to be seen.
The inflationary impact of this new rate-cutting cycle also remains to be seen. There are real concerns among several commentators that it could be serious and could require interest rates to rise much further on the next up-swing of the cycle. The Fed, on the other hand, is hoping that a slowing economy will be its own brake on inflation.
We see significant, long-term weakness for the US dollar ahead, coupled with higher commodity prices as interest rates are cut further. In the short-term, we expect US equity markets also to do well, with the occasional bout of volatility as more dead whales float to the surface of the mortgage market in the coming year.
Asia Including Japan
The sentiment for emerging markets still appears to be strong as there are fundamental improvements in many countries and high commodity prices look set to drive equity markets further. Many investors believe that equity markets are not overvalued and are supported by good earnings growth. Hong Kong has benefited from the recent cut in interest rates and the Hang Seng is still buoyed by the relaxation of laws dictating where mainlanders can invest. Although the rules are still hotly contested H shares have increased by over a third in recent weeks. Hong Kong property is also expected to do well. The same is not true for Chinese equities though and concerns about inflation have resulted in a freeze on Government-controlled prices. Inflation will remain difficult for China to control in coming months as the problems have arisen as a result of food prices, which is a significant proportion of expenditure for most households.
Japan needs political stability to help it stand on firmer ground and the likelihood of this happening seems tentative. The new prime minister, Yasuo Fukuda (aged 71), seems like a caretaker until the next general election.
Europe Including UK
Inflation continues to be an issue in Europe although it is less of a threat than previously. With oil prices on the increase, the European Central Bank will have to remain vigilant in coming months as recent reports suggest that prices have risen due to the International Energy Agency predicting that the global demand for oil will remain high. Unfortunately supply is a different matter as OPEC has announced that output will only increase by 500,000 barrels a day from November. Unemployment in Europe is at its lowest since records began in 1993. This is positive news so far as it has not generated any wage pressures but again the ECB will have to ensure there is no risk of this happening. Currently there is still no sign that retail spending is a cause for concern in mainland Europe and with luck this will remain the trend in the next few months. The UK is not such a bright picture, however: house prices are starting to fall, slowing activity - and households' saving ratio has fallen to a record low. This is largely a result of increased interest rates which have reduced disposable income and the consumer needs to cut back going forward. The effect on the consumer and consequently inflation will be clarified in coming months as some believe that rates have risen far enough and the increase in house prices has lead the consumer to feel less inclined to save and spending can be sustained at sensible levels. The other side of the coin is that house price inflation doesn't fall significantly and interest rates need to rise further. Rates look set to remain at their current level into next year however.
Summary
Global economic growth looks set to ease into 2008 as the world slows as a result of a slowing US economy and the full effect of problems in credit and money markets. Emerging markets could continue to be strong and hence global growth could be around 4.25%, which is above its long term average. Inflation looks set to ease as economies slow but food and energy prices remain a threat to core inflation. Inflation rates look set to be inline with those forecast with the exception of Japan. Modest growth and falling interest rates make the outlook more positive for equities going in 2008; but a likely recession in the US and likely further problems in the credit markets are likely to take some of the shine off equity markets, particularly in Europe and the Americas. Our preferred investments remain (as they have been for a long time) precious metals, oil and gas, plus funds of hedge funds and Asian equities; but we are mindful that a worse credit crunch could still lie ahead if banks continue to refuse to lend while they try to repair their balance sheets after the damage caused by mortgage derivatives.
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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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