08/01/2008

Navigating the Rapids

Investors are warned that the upturn in market volatility seen in 2007 will continue well into 2008, before more settled conditions eventually appear, according to analysis published today by leading investment house, Standard Life Investments.

In the latest edition of Global Outlook, its quarterly investment view, Standard Life Investments considers the interlinked risks investors will face over the coming months, focusing on tight credit conditions, the rise in headline inflation driven by commodities, the squeeze on corporate margins, and elevated levels of risk aversion.

Andrew Milligan, Head of Global Strategy at Standard Life Investments, said:

"A variety of stories worried investors towards the end of last year, including larger than expected write-offs by investment banks, a series of downgrades by ratings agencies, and signs that the reduction in credit availability is beginning to affect both small businesses and many households. A major concern for investors is whether all the bad news has been seen, amidst a growing realisation that the answer is 'no'."

"Offsetting such worries, high profile actions by the monetary and financial authorities periodically reassured investors. While these initiatives have attracted headlines, more mundane but nevertheless important work is going on behind the scenes. Our analysis of the credit market turmoil concluded that a period of overly easy credit has come to an end, and a new era has begun where both the availability and the cost of credit will be altered significantly. Secondly, we concluded that the adjustment period would be lengthy as balance sheets across an array of financial institutions are not where management would like to see them. Hence, recent sizeable write offs and capital injections from sovereign wealth funds are most welcome, but much more work needs to be seen."

"Central banks face a dilemma in coming weeks, whether to pay more attention to the rise in headline inflation, a barrier to easier monetary policy, or to look through these concerns to the more favourable performance of core inflation."

"Our House View continues to focus on the more stable core measure, as ultimately this will determine central bank behaviour. Nevertheless, long term factors need to be monitored, for example the degree of competition from emerging markets, and the impact of food and energy prices on inflation expectations and then wage pressures. Downward pressure on the consumer and housing sectors in coming months suggest that price discounting will once again become more widespread. Ultimately, other central banks will join the Federal Reserve, the Bank of England and the Bank of Canada in cutting rates. 'Watch what they do, not what they say'!"

"It is no surprise that risk aversion is elevated against the backdrop that the US could enter a recession in 2008, causing considerable downgrades to corporate earnings which are already under pressure from higher input prices. Our House View expects weak sub-trend economic growth, and we are monitoring the necessary triggers for a much worse downturn. The US housing recession remains a multi-year event. As this widens out to impinge other parts of the economy, and combines with local factors in other countries, the world economy will re-couple, rather than remain de-coupled, with very few countries avoiding more moderate growth in 2008."

"During the year ahead, high quality bonds and more defensive equity markets are expected to perform better than property and cash. Valuations are expected to become more of a concern across several asset classes, noticeably emerging market equities. There are strong structural arguments justifying their current high ratings compared to history, for example large current account surpluses mean that they are less vulnerable to changes in global liquidity flows than say during the 1997-98 emerging market crisis. However, their ability to de-couple from the downturn in the US and other OECD economies appears limited, especially so against a backdrop where countries like China are beginning to tighten monetary policy more aggressively in order to restrain inflation pressures."