Commentary – Quarterly bulletin

Looking into the abyss

Volatility has become the one area of consistency in the investment markets in

recent months.

30 July 2008

Market sentiment has ranged from mild optimism back in March that the credit crisis was being contained to one of extreme pessimism in mid-July. These sentiment swings have played out in dramatic effects across the markets. Although investors seem to be pulling back from their worst fears, it is still too early to say with any degree of certainty that we have seen the worst.

The global economy has been hit by several shocks.

It started last year with the credit crunch which is taking longer to resolve than was at first expected. If anything, those wishing to borrow are finding it harder than ever to secure loans. Secondly, the soaring cost of oil and food is cutting into discretionary spending and changing consumers’ behaviour. More recently, rising unemployment or at least concern about job security is also dampening consumer sentiment. These blows are almost certainly going to inflict a recession or a prolonged period of sub-par growth on the global economy.

Inflation has also risen sharply and prompted some concern that we may be returning to the ‘stagflation’ era of the 1970s when growth was weak and inflation soared at the same time.

The key to this is wages. Last time, the labour force was successful in pressing wage claims to restore real income lost to inflation and we ended up in a wage-price spiral. This is now less likely as trade union power has weakened and companies are exposed to a much higher degree of international competition. Nevertheless, we need to monitor wage settlements to see whether we are going back to the bad old days. The chart provides the history of the last five years.

The recent decline in equity markets has been associated with more widespread concern about the profit outlook.

At the beginning of the year, falls were very much concentrated in the financial sector but in the recent collapse, stocks whose profits are geared to the more sensitive economic sectors have taken a bigger hit. So far, the focus has been on profit expectations for this year which have been lowered across a broad range of sectors. There is still scope for further cuts to this year’s profits and certainly for next, so markets may well suffer further falls if these come through. Profit margins are still relatively high in most countries, as is the ratio of profits to GDP and it would be reasonable to see these revert towards the historical average during a period of economic underperformance. Although there is now good value in most of the markets (in the sense that the price/earnings ratio is as low as it has been for about 20 years), investors are unlikely to be attracted by this until they have more confidence about the degree of the coming profit decline.

There has been an unusually unbalanced distribu­tion of share price movements in the past year.

An analysis of the movements of the individual share prices making up the FTSE100 index illustrates this phenomenon. Near the recent market low, more than twice as many share prices had fallen more than the index as had fallen less than the index since their respective highs in the past year. This is shown in the chart below and serves as a timely reminder that diversification within a portfolio reduces volatility.

I have observed in the past that the rise in equity market volatility since the spring of last year may be a lagged response to rising US interest rates in the period 2004-2006. If I am right, volatility should ease back around the end of this year but until then we may be in for more turbulence. Long-term investors should take advantage of periods of weakness, such as we have seen recently, to add to positions.

The sharp rise in gilt yields during the second quarter reflected rising inflation expectations.

The rise in yield was mirrored in foreign government bond markets, but elsewhere the inflation expectation component was less instrumental in the rise. Monetary policy in the UK is on hold with the Bank of England torn between easing to relieve the housing and credit markets and tightening to deal with rising inflation expectations. This is the first time that monetary policy in the UK is being set by an independent body at the time of a conflict between inflation and growth requirements and the normal interest rate cuts to help along the gilt market may be delayed compared to previous cycles. As I argued above, it appears unlikely that we are entering a prolonged period of high inflation and yields may ease further in the months ahead. Eventually the Bank should be able to provide extra support through lower interest rates. The gap between gilt yields and corporate bond yields has been edging up again and as we move through the economic downswing cycle it is likely that the gap will widen further as defaults rise.

Commodity prices have turned weaker in recent weeks.

Analysts continue to debate how much of the sharp rise in commodity prices in this cycle has been due to the weight of portfolio buying as opposed to a change in the supply/user-demand balance and I suspect this debate will run and run. It is clear that demand has risen faster than supply in recent years and that inventories are low. In these conditions, small changes in either supply or demand can create disproportionate price effects. It is also the case that big price changes can affect demand more quickly than supply which has a relatively long lead time. The rapid rise in petrol prices as the oil price went from $100 to nearly $150 is having an effect on driving behaviour and demand growth is slowing. We may be in for a period of volatility in commodity markets as well as financial markets.

— Ken Forman

Ken is an investment business consultant who spent 30 years as an analyst and portfolio manager at Standard Life Investments.