Wednesday, 31 December 2008
Ready For a Rally?
For much of late 2007 and early 2008, many people in the “real economy” wondered what the financial sector was panicking about. It was only in the autumn that business conditions turned savagely down. By extension, it is quite possible that in the course of 2009 company executives will be bemoaning a slump in both demand and profits at a time when stock markets are rallying in anticipation of recovery in 2010.
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Ready For a Rally?
Markets could decouple from the economy in 2009 – in a pleasant way for equity investors
The Economist
30 December 2008
Soothsaying is not a very respectable profession. Like Cassandra, those whose forecasts are correct tend not to be believed. Most people are drawn into extrapolating from current trends and are thus surprised when things change. That is one reason why economists are so hopeless at predicting recessions.
In late 2007 Buttonwood ventured to forecast that both commercial property and eastern European economies would be a source of trouble in 2008. Although those predictions turned out to be right, neither was remotely close to being the big story of the past 12 months.
The sheer scale of the damage wrought on the banking sector by the credit crunch was a surprise to almost everyone. It is true that some people forecast that the debt burden of English-speaking consumers would lead to economic calamity, but many of those Jeremiahs had been predicting disaster for a decade or so.
If 2008 was the year of systemic risk, particularly in the financial sector, 2009 seems likely to be a year dominated by specific risk. In other words, we can be sure that more companies will default on their debts. The current default rate on American high-yield bonds is less than 4%. Barclays Capital is predicting a rate of 14.3% by the second half of 2009.
Inevitably some of the defaulters will drag other companies down with them. Equally certain is that the downturn will lead to the emergence of financial scandals, along the lines of Enron and WorldCom in 2002. Recessions uncover what auditors do not, as the old saying goes.
But corporate collapses would hardly count as the big surprise of 2009. What would? Country risk also returned in the course of 2008, with Iceland the most notable example. But although emerging-market bond spreads have widened, they have not done so to anything like the same extent as high-yield debt. There may be some more country defaults in 2009, as export volumes and commodity-related revenues slump, and as Western banks, under political pressure, focus on domestic rather than international lending.
Markets have a terrible tendency to inflict maximum pain on the maximum number of investors. For example, if the consensus is bearish on the dollar, investors will be positioned for a decline in the American currency. If the greenback then rises, investors are forced to buy the dollar, pushing the currency up even further.
David Bowers of Absolute Strategy Research argues that investors are positioned as if 2009 will see a rerun of the 1930s Depression, having sold equities and commodities and pushed government bond yields down to very low levels. But what if all the measures taken by governments and central banks actually work? Interest rates have been slashed, taxes have been cut, money has been bumped into the banking system. The effect of these policies might come through in 2009, since both monetary and fiscal policy always take a while to have an effect.
Mr. Bowers reckons that the fourth quarter of 2008 may have seen an “inventory shock”. Faced with credit constraints and forecasts of plunging consumer demand, companies slashed production. The result is that they are entering 2009 with very low inventories. If consumer demand turns out to be better than expected, then companies may find themselves desperate to get hold of components and raw materials. Pricing power will return and commodity prices will shoot back up.
That would definitely count as a big surprise. Morgan Stanley, for example, is forecasting a fall of 30% in capital expenditure between now and mid-2010. If Mr. Bowers is right, low government-bond yields could lose their appeal and equities could rebound. Income-seeking investors seem unlikely to get much of a return from cash this year.
An equity rally could occur even if the global economy is in for a prolonged period of weakness. Two of the best years for Wall Street in the 20th century were 1933 and 1935, despite the severity of the Depression. The value of the London stock market more than doubled in 1975, in the midst of a stagflationary crisis and the year before Britain had to ask the IMF for an emergency loan.
For much of late 2007 and early 2008, many people in the “real economy” wondered what the financial sector was panicking about. It was only in the autumn that business conditions turned savagely down. By extension, it is quite possible that in the course of 2009 company executives will be bemoaning a slump in both demand and profits at a time when stock markets are rallying in anticipation of recovery in 2010.
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