The US economy should shrug off most of the fallout from the turmoil in financial markets, but it will be well into next year before the drag from the housing market wanes, but there are tentative signs that Japan's mid-cycle slowdown is coming to an end, bolstering the outlook for Japanese equities. For the past 18 months, European growth has been consistently surpassing expectations but there are now signs that growth is peaking. UK economic activity is currently upbeat, but with UK estate agents noticing a marked slowdown in the housing market, consumer spending is set to slow in the coming months.
During the recent market shakeout, it was not the extent of the fall in global stockmarkets that was notable – even at their lowest point, stockmarkets had fallen less than 10% from their July peak. Instead, it was the extent to which the turmoil that began in June with the collapse of two Bear Stearns hedge funds quickly infected all markets. As other investors around the world discovered that the portfolios of mortgages they had bought were not nearly as risk-free as their AA and AAA credit ratings suggested, the contagion spread, bringing down investment funds as far afield as Australia, triggering the near-collapseand subsequent rescue of German bank IKB. With investors wary of which institution might be afflicted next, and hence reluctant to roll over loans to even the most reputable banks, the money markets began to dry up, threatening the funding on which the whole banking system depends. Credit spreads and short-term money-market interest rates jumped, as investors demanded higher compensation for the perceived extra risks. Central banks have had to pump extra reserves into the money-market to make up for banks' unwillingness to lend to each other. Higher funding costs – and in some cases the complete drying up of funds – have forced speculators to rein in their positions, triggered the sell off across a swathe of markets from equities to currencies. With investors unable to find any buyers for the mortgage portfolios with which the problems lie, all liquid assets have fallen sharply in the resulting fire sale.
As fears of a major banking collapse have receded, the markets have recovered a little confidence but they are likely to remain unsettled for a little while yet. Many investment funds report their performance only periodically – partly because of the difficulty of estimating the value of the most illiquid assets – with the result that many investors are likely to be sitting on losses they know little about. As a result, there is likely to be further investor redemptions in the weeks ahead, triggering more asset sales. Although the sell-off in equity markets looks to have gone too far, in the current environment global stockmarkets will find it difficult to make any headway.
Part of the reason that the markets have recovered a little confidence is the expectation that the Federal Reserve will now cut interest rates at its next meeting. However, with the threat of a credit crunch ebbing as liquidity trickles back into the money markets, policymakers are likely to disappoint expectations of sharp cuts in interest rates. Credit spreads have widened – the premium over government bond yields that investors demand in order to hold BAA-rated corporate bonds, for example, has widened from 1.6% in May to 2%. However, spreads have only reverted to their long-term historical average. In the wake of the collapse of the technology bubble in 2002, BAA spreads ballooned to just under 4%. Moreover, expectations of lower interest rates have dragged down government bond yields to such an extent that corporate bond yields are only 50 basis points higher than their level at the beginning of the year. As a result, the impact of the credit market squeeze on the broader economy is likely to be fairly contained.
However, at the same time, the sharp rise in the number of sub-prime mortgages – loans to borrowers with poor credit histories – and the lack of investor interest in new issues of mortgage-backed securities, will cause lenders to tighten their standards; since the beginning of the downturn in 2006, more than 70 sub-prime lenders have closed or sold their operations. As a result the housing market looks set to remain a drag on growth well into next year. At the height of the house-price boom in 2005, US households withdrew an amount equivalent to 5% of their annual disposable income from the value of their houses, by remortgaging or downsizing, a substantial boost to spending. With house prices now falling, and the stock of unsold properties at a 17-year high, consumer spending will continue to slow.
One reason why consumer spending has held up better than might have been expected, given the slump in the housing market, has been the buoyancy of the stockmarket. A key concern for policymakers, therefore, would be a more protracted fall on Wall Street. But with the benchmark S&P 500 Index having fallen less than 10% from its July peak, the impact on consumer confidence and spending from the recent market turbulence is likely to be fairly small. Of course, if policymakers fail to deliver the interest-rate cuts that investors are expecting, Wall Street may come under renewed pressure. Inflation appears to have stopped decelerating, limiting the Federal Reserve's room for manoeuvre. Nevertheless, the prospect of some easing of policy remains a key support for Wall Street, as does the fact that the recent fall leaves US equities looking good value.
Moreover, before August's shakeout there were signs that activity was beginning to reaccelerate despite the continuing downturn in the housing market, with business confidence picking up and manufacturing recovering from its contraction at the end of last year. Perhaps surprisingly, so far there is no sign manufacturing is faltering despite the continuing woes in the housing market. Activity should continue to improve gradually, although the continuing slump in the housing market means it is unlikely to return to its trend rate of around 2.5 to 2.75% a year until next year. Now that activity is picking up, Wall Street should begin to outperform other equity markets, and valuations look attractive relative to government bonds. At least government bond yields look attractive relative to yields in other markets, given the outlook for interest rates. The interest-rate environment is not particularly favourable for the US dollar, but given investors' current nervousness – which is likely to boost demand for US government bonds – and the dollar's undervaluation, the currency is unlikely to come under too much pressure.
For some time now, the Bank of Japan has argued that with the country's decade-long slump now only a painful memory, the current level of interest rates – just 0.5% – is far too low, and that it needs to continue raising them towards a neutral level, estimated to be between 2.5% and 3.5%, before inflation begins to grow out of control. Adding credibility to the Bank of Japan's argument is the fact that over the past 4 years, the economy has grown on average 2% a year, three times as quickly as it managed between 1991 and 2000. However, despite the recovery now being in its 5th year, inflation has failed to reassert itself and prices are still falling. The Bank of Japan, though, is worried that inflation will quickly reaccelerate over the next 18 months unless it takes steps now to prevent it, which is why it had signalled that it was likely to raise interest rates in its August meeting. The shakeout in global markets meant that policymakers had to postpone their next rise. In part this is because any slowdown in the US, still Japan's most important export market, will hurt Japanese exporters. Moreover, whilst Japanese markets may have escaped relatively unscathed, the yen's sharp appreciation threatened to squeeze growth, through its effect on exports.
Another reason for not rushing another interest-rate hike has been the mild downturn this year, with exports stagnating – particularly to the US, and Japanese firms cutting back on investment in new machinery and equipment, a key driver of the country's recovery. But there are tentative signs that activity is beginning to pick up again, with export orders and investment spending reaccelerating. Slow wage growth had been undermining consumer spending, despite strong employment growth. A marked improvement in summer bonuses – which can amount to one or two months' salary – is boosting wage growth, promising an upturn in consumer spending. The improving economic outlook, should help Japanese equities outperform, and is already encouraging investment analysts to upgrade their profit forecasts for the first time since the beginning of the year.
Although the yen ricocheted from its 9-year low during the market shakeout, the currency's reversal in fortunes is likely to prove short-lived. In recent years, an increasing tide of Japanese savers have sought a higher return in currencies other than those they could earn at home, helping to drive down the yen. While some of these investors may be deterred from continuing toinvest overseas, following their recent losses from the yen's jump, with Japanese interest rates set to stay considerably lower than in other markets for the foreseeable future, the yen remains unattractive, and should resume its slide. Japanese bonds also look unattractive, following the recent slide in 10-year yields to 1.6%.
Ever since economists first began upgrading their forecasts for euro zone economic growth 18 months ago, European equity markets have been outpacing their peers; the Dow Jones Euro Stoxx Index of European equities, for example has risen almost 25% since the beginning of 2006, while the Japanese stockmarket has gone sideways. The euro has appreciated 15% against the US dollar, reaching a lifetime high. But economists have stopped upgrading their growth forecasts, both for this year and next year. Given the exceptional strength of activity lately, economists had already been predicting that growth would slow from 2.7% this year to 2.3% next year, and lead indicators suggest activity may cool more than investors currently expect.
The key driver of the euro zone's recovery has been a boom in investment in new machinery and premises; German construction has been expanding for the first time in a decade, for example. But construction orders have begun to cool, and although exports of machinery are still buoyant, domestic orders have begun to slow. Consumer spending has picked up, but has still been growing at half the rate it managed at the end of the 1990s. Although households are as confident about the economic outlook as they have been at any time in the past 15 years, they remain more wary about their own finances, reflecting the weak wage growth that has been the price the euro zone has had to pay in order to become more competitive. It does not look likely, therefore, that a pick up in consumer spending will compensate for any slowdown in business investment.
The prospect of a slowdown suggests European equity markets' spell of outperformance is due to come to an end. Investor sentiment though, is still positive and it is set to disappoint only moderately as growth settles down to its trend rate of around 2% a year. The pending slowdown is unlikely to be sufficient to persuade the European Central Bank not to raise interest rates once more given the recent strength of activity, although it may decide to wait until more calm has returned to the markets. Nevertheless, a peak in interest rates now looks close, and evidence of weaker growth means European government bonds look attractive compared to other markets. The interest-rate outlook still favours the euro, but in the current unsettled market environment, the currency is unlikely to make much ground.
Even before the recent market turmoil, the members of the Bank of England's Monetary Policy Committee were fairly divided on the appropriate path of monetary policy. Some argued that the economy was already at full capacity and that inflation pressures were in danger of growing out of control, while others believed the labour market was looser than might first seem, given that the unemployment rate at 5.6% is only a little higher than the 30-year low of 4.7% it reached in 2005.
Certainly wage inflation is exceptionally subdued. The surprise fall in inflation to 1.9%, the first time it has fallen below the Bank's 2% target in 18 months, will add to the debate. Nevertheless, much of the fall was due to a dip in food inflation. With soaring wheat prices worldwide driving up the price of animal feed, and the recent floods across much of the UK having devestated vegetable crops such as potatoes and broccoli, the recent slowdown in food inflation is unlikely to last.
At the same time, there are signs that higher interest rates are beginning to have an impact on the housing market and on consumer spending. The deterioration in sentiment amongst estate agents, as measured by the RoyalInstitute of Chartered Surveyors monthly survey, heralds a slowdown on the high street in the coming months. Now that consumer debt is a record 145% of household income, compared to 100% only 6 years ago, consumer spending is likely to be more sensitive to each change in interest rates than was the case when debt was lower. Moreover, the rises in interest rates over the past year are unlikely to have had their full impact. Over the past two years, as it has become clear that interest rates are on a rising path, applications for fixed-rate mortgages have surged at the expense of traditional variable rate mortgages; over the past two years around 70% of mortgages have been at fixed rates. Most borrowers, therefore, have so far been insulated from rising interest rates. Now however, many of those fixed terms are beginning to come to an end, and with the average rate on a tracker mortgage 5.85%, compared to the average fixed rate over the past 2 years of 5.15%, many borrowers are only now facing a steep rise in their interest payments, which is likely to cool consumer spending in the months ahead.
Although consumer spending has softened, the economy has still been growing at an annualised rate of 3% over the past year, helped by the fact that business investment has been growing at its fastest rate since the late 1990s, and an improvement in manufacturers' fortunes on the back of strong demand from the euro zone. With growth above the UK's temporarily elevated trend rate of 2.75%, policymakers are likely to remain cautious about the prospects for inflation, particularly with firms enjoying their strongest pricing pressure for years.
Notwithstanding the prospect of a slowdown, therefore, another interest rate rise still looks likely, despite the financial market turmoil. But although another interest-rate hike ought to be good news for the pound, with the markets nervous and the currency overvalued, the currency is likely to struggle.
While growth looks likely to slow, as consumer spending and the housing market cool, the fact that growth is currently relatively upbeat should help UK equities to outperform markets in Europe and elsewhere where the growth outlook is now looking less promising. Stocks in the UK also look better value than their peers in other markets. The same is also true for gilts, with 10-year yields around 5% offering an attractive premium over yields in other markets, especially now that UK interest rates look close to a peak.
Commentary
Issue 30
Market Outlook
September 2007
HAYDN DAVIES, BARCLAYS GLOBAL INVESTORS
Originally published in the September 2007 issue