29/11/2007
Perspectives - November 2007
It is instructive for any investor to look back at previous decisions. Some judgements were right, some were wrong, and we need to learn lessons from both. On occasion, an investment call is relatively easy to make. In my previous Perspectives article, I warned that ‘Certainly there are some similarities between the current situation and the events of 1998, but our analysis emphasises the differences. We warn that the credit market’s problems are not yet over. The outlook for financial markets may not be as rosy as some commentators suggest’. November indeed saw a fierce sell-off in equity markets, as more investors understood the extent of the problems facing financial stocks, and realised tighter liquidity could force the US economy into recession.
What about a longer term time scale? It is customary at this time of year for me to look back, before looking forwards. In Perspectives 12 months ago, our conclusion was ‘we recommend investors take a cautious tack, in view of higher levels of market volatility. The good news is they can prepare themselves for a return into buying riskier assets, as and when bad news is fully priced in. We do not think that the end of the investment cycle is near, and hence equities and bonds will out-perform cash over time’. Fortunately, such a statement appears more right than wrong! Markets have been volatile; after all, the FT All Share has seen three declines of around 10% each this year! I would admit that such volatility means that the relative out-performance against cash has been positive but rather variable! Investors have either needed to be fleet of foot in terms of tactical asset allocation, or taken a long term view looking through those cycles.
Other aspects of our previous analysis are even more relevant today. At the end of last year, I wrote: ‘There has been a plethora of leveraged structures, some of which are rather complex, attractive to certain investors as they supposedly deliver a high return with apparently low risk. Problems in this area could encourage a flight to quality’, and ‘The second risk is the earnings outlook. The underlying trend is slowing, and should become more apparent by next spring. The key issue for investors though will be whether earnings growth remains positive or actual declines in profits are seen’. The flight to quality has been obvious in the dramatic events of August and again November, while the inexorable squeeze on margins meant that US profits in the third quarter experienced their first year on year decline since 2003.
Looking ahead to 2008, the House View remains on a cautious tack. This reflects concerns about three main issues: first, that liquidity problems will persist, secondly that the US economy is entering a serious downturn, and thirdly that central banks face a dilemma over inflation.
A number of commentators are understandably concerned about the tensions in wholesale money markets into year end, against the backdrop of rising losses for many banks from holding sub prime debt. These issues are simply parts of a wider problem: a reassessment of the pricing and availability of a whole range of credit instruments not just in the US but globally. Credit market de-leveraging will continue until financial institutions bring their balance sheets back into order. In this respect, an important issue for investors to monitor in 2008 will be how and when the regulator changes the rules.
Turning to the US economy, the housing recession is set to dampen consumer spending in many regions, while parts of the corporate sector face a margins squeeze, from higher unit labour and raw material costs. Much of this is already priced into markets. Hence, a major conclusion from our analysis is that investors should pay more attention to developments in Europe and Japan. A co-ordinated slowdown across the major OECD economies would have much more serious implications for corporate revenues.
Thirdly, pressures are growing on central bankers, not only to ease liquidity tensions but potentially to relax monetary policy significantly. After all, US, UK and European two year bond yields are currently between 0.2-0.8% below the official interest rates in those countries. However, inflation is a major issue. Higher commodity prices, partly driven by the lower US dollar, are pushing headline inflation towards worrying levels for central bankers. If such concerns delay rate cuts, the market reaction could be serious. Conversely, core inflation, excluding food and energy, remains well behaved, and should improve into 2008 as spare capacity is created. Will central bankers focus instead on this more favourable trend, when determining the correct path for monetary policy?
In conclusion, we recommend that investors take a more cautious tack into 2008, as markets will remain volatile. Valuation opportunities are certainly appearing, but so are risks for investors caught on the wrong side of an aggressive position.
Andrew Milligan, Head of Global Strategy at Standard Life Investments
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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