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ITEM PF6E
PENSION FUND COMMITTEE – 26 NOVEMBER 2008
OVERVIEW AND OUTLOOK FOR INVESTMENT MARKETS
Report by the Independent Financial Adviser
1.
Although consensus estimates for economic growth have been cut
substantially in the last three months, they are still probably well behind the
curve. Consensus estimates are shown below, with those for three months
ago in brackets:
Real economic growth %
UK
USA
Eurozone
Japan
2007
3.0
2.0
2.6
2.0
2008
(1.7) 1.2
(1.5) 1.8
(1.7) 1.3
(1.3) 0.9
2009
(1.3) 0.9
(1.7) 1.4
(1.4) 0.9
(1.5) 0.9
It was confirmed that the UK entered recession in the third quarter of 2008,
with growth declining 0.5% and clearly the trend is down. Retail sales fell
0.4% between August and September, unemployment has risen for five
consecutive months, industrial production is falling and the Purchasing
Managers Index has fallen to 41, the lowest level since the series started in
1992. The Ernst & Young Item Club of economists reckons the economy will
contract by 1% in 2009, reaching bottom in the middle of year, before
expanding 1% in 2010, so a weak recovery. The trend is much the same in
the USA with retail sales declining 1.2% in September, consumer confidence
falling from 70 to 57, its fastest decline since records began in 1978, industrial
production dropping 2.8% in September, its biggest fall since 1974 and
unemployment heading sharply upwards. The outlook is similarly darkening
for the Eurozone, but Japan is still expected to just miss going into recession.
2.
Against this background there are also the imponderables in the western
world of how far the over valuation of house prices will correct and how much
the consumer will retrench to reduce his hugely over borrowed position, not
just on mortgage debt, which in the UK is on a per capita basis the highest in
the world, while the savings ratio is at a record low, having turned negative in
the third quarter of 2008. House prices are still falling, transactions are at a
new low level and mortgage arrears, the numbers in negative equity and
repossessions are rising rapidly. The further two big uncertainties are first, the
relationship between the stressed financial system and real economic activity
and second the extent to which the financial stresses will be reduced by the
raft of measures announced in recent weeks by governments and central
banks.
3.
The developing world is now being impacted by the credit crunch and those
running balance of payments deficits on current account are, like South
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Korea, being particularly hit hard. Several countries, like South Korea, have
introduced emergency support packages, while several east European/former
Soviet bloc countries have approached the IMF for assistance. Russia has
sustained huge capital outflows and its currency has weakened. Even China
is gradually introducing support measures. However, Asian growth is still
currently forecast to be robust in 2009 at about 7%, with China nearer 9%, but
these growth estimates will undoubtedly be trimmed back.
4.
Western Governments and central banks have been very pro-active in
introducing measures to deal with the credit crunch and to try to limit its
impact on the real economy. While it would seem they have prevented a melt
down of the system through wide spread systematic risk, they may still be
‘behind the curve’ in limiting its impact on the real economy. Clearly further
fiscal measures to support economic growth are required as are more
reductions in interest rates. The current Bank of England rate of 3.0%, which
was cut in two stages from 5.0% (by 0.5% and then a dramatic 1.5%), could
be reduced to 2.0% in 2009, while the US rate of 1.0% which in October was
cut in two stages from 2.0% could be reduced further. The current European
Central Bank rate of 3.75% will probably be cut to 3.25% by the end of this
year and the market have priced in a rate by 2.5% by June 2009. Japan will
probably hold its rate at 0.3%, having cut it by 0.2%.
5.
Only two months ago with oil heading towards $147 and commodity prices
very firm, the concern was that the world was entering a new inflationary era,
alongside the credit crunch. Now with oil and commodity prices, both metal
and agricultural, having fallen substantially (see charts below), inflation is
expected to return to low levels and is no longer seen as an issue, although
the fall in the sterling exchange rate will bring inflationary pressures for the
UK. However, longer term the huge amounts of money being pumped into
money market by central banks and the budget deficit fiscal packages
proposed by many countries could sow the seeds for a meaningful rise in
inflation, if such measures are not reversed in time. Also, the oil price at just
over $60 is now probably below its natural price estimated around $80-$90.
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6.
Inspite of reductions in official interest rates and huge amounts of money
being injected into money markets, interbank market rates beyond call/over
night have only eased a little and remain at elevated levels. Banks and other
financial institutions still do not trust each other to lend to for longer periods,
not knowing who may still hold undeclared or not fully declared ‘toxic’ assets,
such as sub prime mortgages or other junk debt, which would put their capital
base at risk. Thus, three month sterling LIBOR is 5.56% against the Bank of
England’s rate of 3.0%, the three month US$ LIBOR is 2.39% against the
Fed’s rate of 1.0% and the three month Euro LIBOR is 4.60% against the
ECB’s rate of 3.75%. Until rates in the money markets fall substantially,
reductions in official interest rates will not be reflected in lower rates to
borrowers generally and in the mortgage market in particular. In the longer
term debt market, the ‘spreads’ (yield margin over government bonds)
remains wide and the cost of insuring such debt against default (CDS – credit
default swaps) has even increased to record levels, as the charts below
show.
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MARKETS
7.
Since the end of July UK government bond yields on conventional bonds have
tended to settle at lower levels, while those on index linked have risen, the
seeming contrary movements reflecting fears of recession and with it lower
inflation, as the figures below show:
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UK Gilt Yields
10 Year Benchmark
June
2007
5.4%
March
2008
4.3%
July
2008
4.8%
Low
6 October
4.2%
End
October
4.4%
41/4% Treasury 2055
4.5%
4.2%
4.3%
4.1%
4.3%
0.9%
0.5%
0.4%
0.3%*
0.7%
11/4% Index Linked 2055
* On 12 August
8.
The yields on longer dated index link bonds still remain well below the
historical norm that money should earn 2% - 2.5% after inflation. The following
figures show the impact on index linked bond prices if their yields were to rise
to 1% or 2%:
Current
Yield
Current
Price
Price at
1% Yield
Price at
2% Yield
Inflation
Adjusted
Issue Price
224
21/2% IL 2024
1.86%
239
268
235
2% IL 2035
1.18%
146
152
124
126
11/4% IL 2055
0.70%
122
109
77
113
9.
A move in index linked bonds on to a more justifiable yield basis would result
in large capital losses.
10.
The equity market in the UK held above the support level of FTSE 4800 for
sometime, but in early October it fell through that support level and through
the next one of FTSE 4500, to settle in highly volatile trading in the support
area of FTSE 3800-4000. Extreme volatility has been a distinguishing feature
of this bear market, as the chart below shows.
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11.
Two years ago volatility which fell to around 10 on the VIX index, recently rose
to nearly 90, with the FTSE100 index moving over 250 points (7%) in a day
and the Dow Jones (US) average up to 900 points (10%). A lot of the very
recent selling has been done by hedge funds. Prime brokers (part of
investment banks) lend money to hedge funds against collateral and such
borrowings by hedge funds may represent their being leveraged 6 or even 7
times (i.e. borrowings representing around 85% of assets invested). Market
movements, especially in extremely volatile conditions, can result in demands
for substantially more collateral, which require the sale of more liquid assets
such as equities, to reduce borrowing limits, while hedge funds are also
encountering rising redemptions. Some hedge funds now have substantial
liquidity, but is not clear how much more sales will be necessary by other
hedge funds. There have also been redemptions in unit trusts and mutual
funds.
12.
With the equity market having fallen 43% from peak (FTSE6716) to trough
(FTSE3852) it should seemingly appear good value. Consensus company
earnings growth in the UK of 6% for both 2008 and 2009 would put the market
at current levels on price earnings ratios of 8.4 for 2008 and 8.0 for 2009, but
such earnings forecast are wildly optimistic. Historically, corporate earnings
(profits) have fallen 25% on average in a downturn, and if, as seems
probable, this recession is going to be more severe than the average,
corporate earnings could decline by between 30% to 40%.This would make
the market’s price earnings ratio look much less reasonable, although much of
this is already in equity prices. Nevertheless, in retrospect price earnings
ratios are normally high at market bottoms because corporate earnings have
fallen. Historically, the market has stopped falling 3 to 6 months before the
trough in company earnings, which could on current projections be in the
middle to autumn of next year. Further equity markets tend to bottom around
four months after corporate bond markets have reached a bottom.
13.
The corporate bond market did have a severe shake out in early October,
which with spreads (yield margins over government bonds – see charts in
paragraph 6) at record levels by a large margin might indicate it has
bottomed. Also the equity market starts to recover on average four months
before the recovery in the real economy, which could occur in the summer to
autumn next year. Thus, the equity market might have one more short down
leg to test the March 2003 low of around FTSE3300, but even if we have
already seen the market low, there could be a strong bear market rally
followed by a testing of the present low of FTSE3852. If there is a further
down leg, there could be a sharp initial recovery followed by a slow bull
market rise as the market climbs the ‘wall of worry’. The damage to banking
and the general financial structure has been such that it seems unlikely that a
powerful bull market will develop soon, apart from a recovery from any final
dip (see charts in Annex 1). Overall, the process of deleveraging (reducing
debt in corporate balances sheets) still has some way to go. As this process
continues people will begin to move back to taking on more risk. With investor
cash balances high and rising, cuts in official interest rates and hopefully the
reduction of the margin of money market rates over official rates will provide
an incentive to investors to move back into risk assets, such as equities.
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14.
15.
The currency markets have also been extremely volatile. There have been
four principal influences affecting currency markets.
(a)
The unwinding of the ‘carry trade’, whereby operators such as hedge
funds borrow in low interest rate countries such as Japan (official rate
0.3%) and invest in high interest rate countries (such as Australia and
New Zealand). Japanese domestic investors have also been moving
funds to high interest rate countries. Thus the Japanese yen has
hardened from 106 to the US dollar at end September to 92 at one
point, before recovering to 97. This is a huge move that has caught out
many hedge funds.
(b)
The US dollar assuming again in some measure a safe haven status in
the current turmoil in spite of running a huge balance of payments
current account deficit. This trend has been assisted by hedge funds
remitting the proceeds of asset sales back to US dollars, as their
shares are generally denominated in US dollars and to meet
redemptions. Thus, the US$ has strengthened from $1.56 to the euro
at the beginning of August to $1.41 at the end of September to $1.27
currently.
(c)
With the fall in commodity prices, especially metals, the commodity
based currencies, such as Australia and Brazil, have suffered
substantial falls.
(d)
The currencies of countries with balance of payments deficits and
which are more likely to suffer a deeper recession as a result of the
credit turmoil have particularly suffered, the principal country being the
UK. Thus the sterling/US dollar rate which was $1.98 at the beginning
of August fell to $1.78 at end September, then to $1.53 in late October,
before recovering to $1.62. Sterling has probably reached a base for
the time being at this level. In contrast sterling has been steady against
the euro at around euros 1.27 throughout the period.
Commercial property prices have continued to fall and yields have risen
sharply, as the chart below shows:
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16.
Capital values have fallen 19% from their peak last summer. There is
probably further downside, bringing the total decline to at least 25%. This will
lift yields further towards the 8% level, but this will be offset slightly by falling
rents, particularly in central London with job losses in the financial sector. The
market could bottom in the spring/summer of next year.
A. F. BUSHELL
Independent Financial Adviser
November
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ANNEX 1
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