From credit crunch to global recession


David Roche
Published on:

The bad news: in 2008 a global recession is bound to set in. The scant good news: the oil price will fall back and the development of environment-friendly technology will fuel investment.

The story of 2007 was the credit crunch. The story for 2008 will be global recession. Last year, the US home prices collapse was the worst since the Great Depression – a fall of 6% year on year. Starting with the sub-prime defaults, this led to huge markdowns in asset-backed securities and special investment vehicles owned by banks globally.

The sub-prime debacle spread to other credit markets, including inter-bank lending, causing a liquidity squeeze that drove up interest rate spreads to abnormal levels despite the efforts of central banks to inject liquidity and cut policy rates. Eventually, the combined efforts of the Federal Reserve, the European Central Bank and the Bank of England managed to engineer a return to some semblance of normality in inter-bank lending. But the cost of borrowing or insuring against defaults in companies or in their bonds continued to rise sharply.

And there is still a long way to go in the credit crisis. We reckon that ultimate losses to the banks and other leveraged investors across all credit markets could reach more than $600 billion. So far, only $100 billion has been announced.

That is the raison d’être for my forecast of global recession this year. After rising at more than 15% a year for the past three years, global liquidity will probably contract by 5% to 7% over the next 18 months as banks tighten lending standards and the markets for securitized debt (and the derivatives based on that debt) shrink.

Also, the credit bubble in China is set to burst in 2008 as the authorities apply tighter credit controls, the US consumer applies the brakes and the hangover sets in after the Beijing Olympics. The bubble is already deflating in eastern Europe. So far in 2008, global equity prices are down 5% to 10%. Expect them to slide another 10% at least in the first half of this year.

Bond markets last year were characterized by a move from high-yield paper to safe-haven debt. As a result, US treasuries had their best annual return for several years, rising more than 9%, with a 5%-plus return in the fourth quarter of 2007. Ten-year yields dropped below 4%, with significant falls towards the end of 2007’s fourth quarter. The yields on short-term treasury bills plummeted as investors switched out of higher-risk corporate bonds and the commercial paper market in the credit crunch.

US sectoral corporate credit yield spreads

Over five-year government bonds (bp)

Source: Instrategy

I expect government bond yields to stay low while corporate paper rates move yet higher as it is now clear that corporate earnings growth, having risen at double-digit rates for quarter after quarter since 2003, will now disappear. Indeed, earnings will decline in the first half of this year, as consumer spending contracts and lower productivity growth forces up unit costs.

As I forecast at the beginning of 2007, the US dollar took a big hit during the year, down 11% against the euro and 6% against the yen. The weakness was compounded by the beginning of the Fed interest-rate reduction cycle. As that process will continue this year, I expect the euro to reach $1.60.

The biggest gainers against the dollar in 2007 (and it will be the same this year) were emerging market currencies and gold. The Chinese renminbi appreciated faster and will continue to do so this year.

I set a target of $850 an ounce for gold in 2007. That was reached in the fourth quarter as gold hit a 27-year high in dollar terms, rising 32% in the year. As I continue to expect a weaker dollar, stagflationary pressures and rising financial and geopolitical risk, the gold price will head towards four figures by the end of the year.

Is it all doom and gloom for the world economy and for investors in 2008? Not quite. The crude oil price finally hit $100 a barrel in the fourth quarter of 2007 and rose 62% over the year. The supply-demand equation in oil has been tight. However, as the global economy slows in 2008, demand will ease and oil prices will fall back. That will help economies a little.

In 2007, the evidence that the planet is heating up and damaging the environment through greenhouse gas emissions became overwhelming. Governments and business are looking to spend billions over the next couple of decades on controlling emissions and reducing pollution. That opens up new investment areas in clean energy, water infrastructure and emissions technology.

David Rocheis president of Independent Strategy Ltd, a London-based research firm.