This thoughtful article in the Financial Times by Tim Bond, head of asset allocation for Barclays Capital, observes that some obvious fundamental developments haven’t been incorporated into prevailing financial market forecasts, both for developed and emerging markets. It also offers practical investment suggestions in the face of a difficult climate for financial assets.
From the Financial Times:
The outlook for financial markets in 2008 is not encouraging. Although the past five years have seen the strongest global economy since the late 1960s, the expansion has now reached the cyclical juncture at which market returns are typically very weak or negative.
The US economy is leading the way, having already entered a stagflationary phase. Such an environment is poisonous for financial assets. Since 1929, the average real return from US equities, bonds and bills has been markedly negative during years of below trend growth and above trend inflation. Equities, by way of example, average a negative 1.9 per cent real return during such years.
Markets are ill-prepared for this outlook. US profit forecasts remain much too high in relation to economic forecasts. With the consensus among economists shifting towards two to three quarters of US GDP growth averaging close to 1 per cent, the forecast 15.5 per cent rise in S&P 500 operating profits during 2008 is unrealistic. Historically, GDP growth around 1 per cent is associated with a decline in operating profits, yet the consensus among analysts is for a straight line recovery in earnings, starting with the current quarter. Equity markets are also oblivious to the severity of the credit crunch. Despite the recent severe weakening in the credit markets, this quarter’s US financial sector earnings are forecast to be unchanged from Q3. They are then forecast to bounce more than 50 per cent in Q1. Such optimism is misplaced. Rising mortgage delinquencies, stress in consumer credit, a likely increase in corporate defaults, acute illiquidity in the wholesale money market, rising competition for retail deposits and the need to issue fresh capital are all factors arguing for weak financial earnings. Additionally, future credit creation will be slower than the frenetic pace of the recent past.
Neither the US equity market nor the corporate bond market appear aware that a profit margin contraction is under way. The GDP data for the third quarter showed non-farm business costs rising at a faster pace than output prices for the fourth quarter in a row, due to a combination of weakening pricing power and rapid unit labour cost growth. These factors are unlikely to change over the next couple of quarters. There is no reflection of these trends in equity earnings forecasts. Equally, with non-farm business debt up 30 per cent since the start of 2004, against a 27 per cent rise in pre-tax profits, rising leverage ratios will increase corporate defaults in 2008, a prospect not fully discounted in credit spreads.
Outside the US economy, growth is still strong. However, the consensus forecast of largely unchanged growth rates in the developing economies is too optimistic. Most developing economies are showing symptoms of overheating. Consumer inflation rates have risen to uncomfortable levels, with asset prices exhibiting excessive exuberance. Although monetary authorities have yet to move from very inflationary policies, such a shift may begin to occur next year. Since the alternative is a steadily increasing inflation rate, the question is when, not whether, the developing world opts to slow growth. The net result is that 2008 should see markets starting to discount the rest of the world economy following the US into the below-trend growth/above-trend inflation quadrant of the business cycle.
This implies weakening returns from financial assets, with a phase of negative returns from bonds, followed by cyclical bear markets in equities and commodities.
During such periods, investors are best served keeping most of their allocations in cash and inflation-linked securities. Those with flexible guidelines can generate positive returns from shorting overvalued assets. This year’s shorts were corporate credit and small-cap equities; next year’s are probably Asian stock markets, US small-caps and commodity currencies. For the long-only investor, however, sizeable dollops of cash, index-linked bonds and patience should prove a successful combination, preserving firepower for a period in which forced liquidations may offer some very attractive investment opportunities.