In the third quarter of 2007, credit markets were hit everywhere as the sub-prime loans crisis in the US went global. The cost of securitized debt rose sharply and banks became fearful of lending to each other. As a result, interbank rates moved out sharply from the policy rates set by central banks. The resulting credit squeeze forced central banks to flood markets with extra liquidity and in the case of the Federal Reserve to cut its funds rate by 50 basis points.
Despite this, global equity markets were relatively resilient. Indeed, they rose 0.5% in the quarter, and the S&P 500 index appreciated by 1.6%, outperforming Europe and Japan for the first time in many a quarter, as those equity markets fell sharply, by 3.4% and 7.5% respectively. Emerging market equities, after suffering a drop following the initial credit squeeze in August, rallied hugely to end up 11.8%.
More chapters
It’s my view that the rally in equities might continue for a while, led by consensus expectations of lower central bank interest rates and the avoidance of global economic recession. But I am much less sanguine than the consensus on a one-year view. There are further chapters in the global liquidity contraction to come, coupled with rising inflationary pressures and the serious risk of global recession in 2008.
Investors seem convinced that the global economy will be unaffected by the credit squeeze. Markets seem to believe that any slowing of growth will help keep inflation low and allow the Fed and other central banks to reverse previous interest rate policies and start to ease.
This is the return of the Goldilocks scenario. It might last a while longer. But as I have argued before in this column, New Monetarism means that the financial sector now sets the tone for the real economy, not vice-versa. The cost of capital is rising, risk appetite will not improve and the yen carry trade has reversed. As a result, global liquidity will contract over the next year and take real economic growth down with it.
US corporate earnings have achieved double-digit growth quarter after quarter over the past five years’ equity bull market. But 2007 second-quarter earnings growth dropped into single digits and third-quarter results suggest that S&P 500 company earnings might well be flat or even fall.
|
S&P-500 corporate earnings growth |
|
Percent year-on-year |
 |
|
Source: Bloomberg |
Up to now, share prices have been driven by huge buybacks and M&A activity. In the third quarter of 2007 that support for the market dropped off sharply. If the liquidity crunch persists, the environment for share price support will wane.
And credit remains tight. Commercial banks in the US and Europe have tightened their lending standards significantly and Libor spreads remain well out of kilter with policy interest rates. Commercial paper issuance has died off as corporations have found it difficult to find buyers for their paper. Although credit derivative spreads have narrowed since the highs of August, they remain well above the levels before the credit crunch began in July.
And although I expect global growth to slow sharply, ironically that does not mean that inflationary pressures will subside, at least in the short term. Slower productivity growth has already driven up unit labour cost growth in the US. Moreover, the disinflationary effect of Chinese and other low-cost imports has worn off. Chinese export price growth is accelerating; US import prices are well into positive territory.
Cut price
Inflationary pressures are likely to grow, not wane, in coming months, making it difficult for Messrs Bernanke, Trichet or King to cut policy rates. Moreover, the price of the Fed interest rate cut was a falling dollar, which depreciated sharply against the yen and the euro in the third quarter of 2007. That won’t help low inflation in the US.
So against the current tide, I’m not very confident about plunging back into the equity market or into bonds of higher-risk assets and emerging markets. The gains that these sectors are currently enjoying are likely to be taken back with interest in 2008.
In contrast, I prefer to stick with longer-term structural investments such as food, clean energy and power. My theme of "filth" (climate change and environmental pollution) operates with double effect in the food sector, as water shortages combine with worsening climate and pollution, especially in large food-consuming nations such as China. Food commodity prices rose 20% in the third quarter of 2007.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com