OPINION: WHILE further falls in share markets are likely and the next six months will remain volatile, we expect the US downturn and slump in shares to be relatively short lived.
More than any time in history mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray that we have the wisdom to choose correctly. – Woody Allen
Introduction
Much of the commentary regarding the
But is the outlook that bad? This note looks at the wall of worry, or risks, now facing shares. Our conclusion remains that while shares are likely to have a rough ride over the next six months or so, and that it is premature to say that we have seen the lows, we don’t see an extended global downturn or an extended bear market in shares.
Our view
The cyclical bull market in shares that got underway in March 2003 now looks to be over. Many share markets had had falls greater than 20% from last year’s highs and the pattern of rising highs and lows in share prices that normally characterises a bull market has been broken by the sharp falls in share markets so far this year. The question is how long will the slump last? Of course, much depends on the
· The US economic downturn will be relatively mild: the Fed is now moving quickly to reflate the economy; fiscal stimulus in the form of personal tax rebates and tax breaks for business to invest will also help boost growth; the corporate sector is in pretty good shape; and the rest of the world is generally solid which along with the lower $US will help US exports. It’s also worth noting that while credit markets are still in dire straits, short term money markets have improved dramatically with interbank lending rates falling dramatically since the coordinated intervention by global central banks last December. There are also signs that the housing market is getting close to a bottom, although
None of this is deny that the news out of the
· Against this
Source: Thomson Financial, AMP Capital Investors
· Given the likelihood of further bad news on the US/global economy and the flow on to profits and ongoing problems in credit markets in the short term, share markets are likely to see further downside, but the bulk of the damage should be behind us (with major share markets having already had 20% or so falls) and the trend should improve through the second half of the year. In this regard:
– share valuations are now very cheap with Australian shares trading on a forward PE of 12.8 times which is well below the average over the last decade of 15.3 times;
– at some point over the next six months shares will start to look forward to better global growth ahead and rally into year end; and
– investor sentiment towards shares has become very bearish which is normally a positive sign from a contrarian perspective. See the next chart which shows a composite measure of various surveys of
Source: Bloomberg, AMP Capital Investors
· Given the difficulty in timing market bottoms the best approach is to average in over the next 6 months.
The Wall of Worry
None of this is to deny the degree of uncertainty now facing investors. There are now a number of worries. One of the best summaries of these was in an article by George Soros in the Financial Times last week. In essence, the two key arguments on the downside are that the Fed’s aggressive moves risk fuelling inflation on the one hand, and on the other they won’t work this time in jump starting the US economy because the US faces a sustained period of de-leveraging (ie debt reduction) which will be made worse if foreign investors lose interest in lending money to the US. Addressing each of these in turn:
Our assessment is that inflation is the least worrying risk. Inflation in developed countries excluding energy and food is running well below the levels preceding previous major global downturns suggesting central banks have more flexibility this time. Despite the huge surge in oil prices we are nowhere near 1970s inflation rates.
Source: Thomson Financial, AMP Capital Investors
Secondly, inflation always lags the economic cycle so with global growth set to slow well below trend this year it is likely that excess capacity and strong global competition will result in falling underlying inflation over the next year or two. If businesses couldn’t raise prices over the last few years of strong conditions how are they going to push up prices as demand weakens? Already in the
Thirdly, barring a
Finally, just because the Fed is easing doesn’t mean inflation is about to take off. That certainly has not been the case after past easing cycles. The problem would only arise if the Fed left interest rates too low for too long, once growth starts to perk up.
Is the debt super cycle over? Probably not. The whole of the post-war period has been characterised by steadily rising debt levels, which some call the debt super cycle.
Source: US Federal Reserve, AMP Capital Investors
Each time there is a financial crisis fears arise that the prior increase in leverage will result in economic collapse and that cutting interest rates and other methods of reflation won’t work. But it has always worked. There is no reason to assume that it won’t work this time around. In the
· Interest rates are still well above zero. Even if rates do fall to zero, the Fed indicated a few years ago that there is still more that can be done, eg buying corporate debt.
· There is still potential downside in the $US, which will help cushion
While leverage associated with sub-prime problems will need to be unwound further it is worth noting that most American households are not having trouble servicing their loans, the fall in fixed mortgage rates in the US is now leading to a pickup in mortgage refinancing which can help stimulate consumer spending and corporate debt is not extreme. So while private sector debt levels in the
The biggest threat would be if foreign investors stopped funding US borrowing and triggered a $US collapse. But the danger of this is low. The countries supplying capital to the
What to watch?
While we are reasonably confident that things will turn out all right and that by later this year the trend in share markets will be back up, it’s reasonable to ask what we would look for to tell us that things might be going wrong.
So here is a list of what to watch for:
On the inflation front: a continuing rise in US underlying inflation measures and the oil price and a collapse in the $US would signal problems.
On the debt super-cycle implosion front: a continued plunge in bank share prices, a fall in US house prices much beyond 15% (they are now down 8% or so); a withdrawal of foreign capital from the US; and a collapse in the $US would signal problems.
By Dr Shane Oliver, head of investment strategy and chief economist of AMP Capital Investors.*
Australian Property Journal