02/10/2007

Navigating through volatile conditions

Although the markets have recently experienced financial turmoil, conditions are not present for a lengthy deep market correction as occurred in 2000-03, 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 major drivers of financial markets. Investors need to assess how the impact of tighter credit conditions, and the response from central banks, will affect corporate earnings growth into 2008.

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

“Two factors suggest that the impact of the credit market contraction will be manageable, rather than triggering a bear market as was seen back in 2000-03. The first is that economic fundamentals are generally supportive across the world. Weakness in the US economy is being offset by continued strength in Asia, the Middle East and much of Europe. The second factor is the strength of corporate sector balance sheets. Unlike 2000-01, companies have generally not raised excessive levels of debt, while cash is at high levels in balance sheets. This should help them withstand the credit contraction better than other sectors of the economy.

“The risks to investors must not be under-estimated. The opaque nature of much of the credit derivatives and asset backed securities markets complicates analysis. There is still an information logjam in terms of ‘who owes what to whom?’, and ‘what are the assets really worth?’ Secondly, central banks are able to support commercial and investment banks, via periodic injections of liquidity into the money markets. However, they do not have the facilities to support directly other financial institutions in distress, such as hedge funds or special investment vehicles.

“The impact on the real economy of the current withdrawal in liquidity remains uncertain. The US housing sector will be affected for some time to come, although an actual consumer recession would require companies to cut payrolls sharply. The cost of credit is rising, albeit by different amounts for different borrowers. Corporate borrowers with a good investment grade rating are only paying modestly higher rates, but sub prime mortgage borrowers considerably higher rates.

“Investors should expect continued volatility. Market confidence is recovering on the back of the aggressive actions by the Federal Reserve and other central banks, allowing tensions in the wholesale money markets to die down. There are signs that bargain hunters are looking at favourable valuations. Nevertheless, a lengthy process of de-leveraging has begun in the credit markets, which will cause pain for those borrowers with weak balance sheets. The outcome is likely to be continued economic weakness for the US, as traditionally it takes up to a year before the benefits of the relaxation of monetary policy by the US Fed start to feed through. The impact of this slowdown on the global economy and thence onto corporate profits growth are the two key issues for investors to address in coming weeks.

“As long as liquidity does flow back into the system, and profits growth remains positive into 2008, we see equity markets as a longer term buy. However, after the turmoil and forced selling seen over the summer, many of the assets that are attractive will be at stock and sector level. Consequently, our fund managers have been examining whether and when to add to selected stocks on their winners lists.

“The House View has modestly added to certain equity positions at the expense of international bond positions, to take advantage of flight to quality fears which we believed were overdone. We raised our position in Emerging Market equities from Light to Neutral, in Japanese equities from Neutral to Heavy, and European equities from Heavy to Very Heavy. The Emerging Market economies are expected to weather the storms much better than say in 1997-98, thanks to their strong current account positions and low levels of external debt. In Japan, we believe positive drivers such as corporate restructuring are not fully priced in by the market. European stocks continue to be supported by restructuring themes, particularly in Eastern Europe, as well as ongoing M&A activity and firm external demand for goods and services”