Review Quarter 3 2007
2007 started fairly uneventfully for the majority of asset classes. Equities experienced a brief pause in February that continued into early March but nothing of any great significance occurred until later in the first quarter. The first signs of trouble for the US housing market became apparent in late March and April when a number of sub-prime lenders began to experience problems and several declared bankruptcy. Such problems were limited to this very specific market segment and as such had no real effect on equity markets, which continued to rise fairly steadily until July. During the summer months however, problems in the sub-prime sector began to infiltrate other areas of the market and the credit crunch started to have wider implications. By the end of July there had been a global re pricing of credit risk and liquidity was drying up as banks were no longer willing to lend to each other. Consequently, the overnight lending rates soared. In order to alleviate some of the pressure, central banks had to intervene to inject liquidity and generate stability. The consequence was that volatility returned to markets at levels not experienced since 2003, and markets corrected sharply in August.
The Fed attempted to combat the slump in markets by reducing interest rates in September and October, this move was appreciated and led to a subsequent rally in the majority of markets. Particularly strong gains during this period have been from Emerging markets. Hong Kong's Hang Seng increased by over 50% from it's low in August following the rate cuts. Even data in the US generated optimism for many commentators; but in November markets started to retreat once again as write offs in mortgage-related securities continued to increase. The financial sector continues to be under pressure as we move into 2008.
For those taking a global perspective it has to an extent been a difficult year. The recovery in Japan didn't materialize and fixed interest markets have been difficult to predict as rate expectations have changed several times. The carry trade has created limited gains during the year and high yielding currencies have appreciated further. Many managers took a cautious stance after the summer months and have consequently missed out on equity rallies deeming capital preservation to be more important at this time. As we enter 2008 most eyes will be on the US as we navigate through the winter months in search of a clearer picture for markets.
Outlook for 2008
It is widely accepted that there will be a global slowdown during 2008, there are few real doom and gloom merchants, although some do predict recession. However, the IMF economic outlook for 2008 suggests that growth will slow from 5.2% in 2007 to 4.8% in 2008. The majority of economists revised their forecasts downwards in November but they are all still predicting moderate growth. The lowest expectation is derived from UBS who expect global GDP growth to be 4.2% in 2008; so even the most pessimistic forecast of growth remains above trend.
The IMF attributes the increasing influence of China, India and Russia (who contributed 11.5%, 9% and 8% respectively to global GDP growth during the first half of 2007) as a significant explanation for continuing growth to be achievable. Emerging markets are expected to contribute more than G7 countries to global GDP growth during 2008. Demand should remain strong in these areas as output is less reliant on credit, local currencies are relatively undervalued and most have lower budget deficits compared to developed countries.
Such optimism has to however, be tempered with an element of realism. The Fed has a precarious balancing act to perform in managing inflation and avoiding recession. It is likely that consumerism will dry up in the US as weaker house prices and increasing fuel prices cause a slow down in spending. Some of the forecasts are also based upon the fact that liquidity will return to the housing sector in coming months. Any further deterioration in this market will have more detrimental effects on the overall outlook for the year. The final risk to predictions is that the strong dominance of emerging market countries doesn't continue as expected, particularly China and India. Any fall in domestic demand there can affect the overall picture - or if the turbulence in global credit markets does disrupt capital flows to emerging markets, which in turn affects domestic markets. This is more likely in European emerging markets where they have large current account deficits and a reliance on bank-related inflows.
Therefore we expect a level of uncertainty to persist early on in 2008 but equities in developed markets are attractively priced if earnings remain strong. Large caps are expected to out perform small/mid caps and there is likely to be more disparity amongst sectors. M&A activity is expected to slow slightly from the incredible volumes seen in 2007 (USD3.55 trillion as at Oct 07). There is still a large amount of cash on balance sheets and as such companies will still be seeking external growth, this is likely to be dominant in sectors such as mining, energy and insurance. The outlook for currencies and fixed income remains uncertain and the lack of clear direction is likely to lead to increased volatility in the short term. Again the Fed has a pivotal role to play. The hope is that as negativity ebbs away during 2008 that the US dollar can rebound. A further catalyst for this would be if the ECB/BoE were forced to reduce rates and some global managers are tentatively positioning themselves for a recovery in the US dollar.
Whilst the overall outlook appears consistent with slower growth the picture is still one of strong growth. The only real certainty is that uncertainty does prevail over markets. Any further credit shocks or further decline in the US is likely to impact other markets. The uncertainty lies in which markets those would be. The result of this will be increased volatility in markets. However, volatility and disparity between countries and sectors creates buying opportunities, and for skillful global managers 2008 should create interesting times.
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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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