Commentary – Quarterly bulletin, January 2009

The end of an era?

We are now in uncharted territory as regards the state of the global economy

28 January 2009

Events have unfolded with breathtaking speed in recent months. Virtually everywhere is now in recession. The financial crisis certainly triggered the downturn in economic activity but there were also some deep-rooted problems which needed addressing and which are described below.

The authorities have stepped in with hefty monetary and fiscal support to try to stop the rot but such is the scale of the retrenchment in the private sector that success within a medium-term timescale is by no means assured.

There are two alternative scenarios as to how the global economy develops over the next two years. In the first, the authorities are successful, leading to a gradual pick up in economic activity. In the other scenario, the expansion of the public sector is insufficient to compensate for the downward spiral in private sector demand as businesses and households reduce debt.

Due to lag effects, we are unlikely to know for some time which of these scenarios is winning. Until there is more certainty, financial markets are likely to remain volatile.

After years of living beyond its means, the household sector now faces a period of adjustment.

In most of the western world, consumer spending for some years has been temporarily inflated by a reduction in savings. The mechanism for this has often been borrowing against rising house prices. The first chart shows the dramatic fall in the savings rate for the UK household sector over the past five years, from what was already a relatively low level

The era of freely available credit is unlikely to return anytime soon as lenders are constrained by the need to rebuild capital after the dramatic shrinkage caused by the credit crisis. They are also likely to be more conservative in their lending policies than had been the case until last year. At the same time, households are also likely to be more conservative in managing their finances by spending less than their income and repaying debt to allow their savings rate to rise to a more sustainable level.

Back issues of our bulletin

The shortfall in domestic savings in the developed world has been accommodated by high savings rates in the developing world.

However, the flow of excess saving from the developing to the developed world has resulted in unsustainable imbalances in the global economy. Overall, a country's external accounts must balance so that a positive balance of capital flows must be offset by a goods and services deficit.

So the reduction in household savings in the US, UK and some other western countries has been accompanied by large and unsustainable deficits in their current accounts mirrored by large and unsustainable current account surpluses in the developing world. It is these imbalances that have put strains on the global economy and arguably led to the financial crisis.

It is encouraging that equity markets have been more stable since their sharp falls in October despite a significant worsening in the economic news.

These falls were largely caused by indiscriminate selling as a consequence of the Lehman Brothers failure and the heightened concern about counterparty risk, although expectations for profits and dividends were also being cut significantly at that time.

Lower prices have helped to make equities more attractive and there are signs that investors are willing to increase their exposure again.

It is important to remember that equities are designed to be long-term investments and that buying when prices are depressed increases the likelihood that they will eventually provide better returns than other asset classes. If we look at the value in an equity investment as coming from the flow of dividends over the very long term, on average only just over 10% of that value accrues in the first three years, and almost half comes from more than 20 years ahead. This is illustrated in the second chart. It should therefore matter little what happens to profits and dividends in the short term provided the expected growth comes through in the long term.

Despite their better performance recently, equity markets are still abnormally volatile and it is likely to take some time for them to settle back into more normal behaviour. The economic risks have risen, as discussed above, and it is possible that there is another wave of profit forecast cuts to unnerve weak holders. Nevertheless, investors are sitting on large cash positions and looking for opportunities to re-enter the equity markets and this may limit the downside risk.

There has been a massive polarisation in the bond markets between risk-free government debt and debt that carries a credit risk.

The security of capital and income offered by the former has come to command a high premium in the form of a low yield, which at least should allow governments to fund their fiscal expansion packages relatively cheaply. At the other extreme, corporate debt offers a yield that includes a default margin wide enough to compensate for at least as bad an experience as occurred in the 1930s. Neither situation is likely to be sustained.

Eventually investors will weigh the inflation risk associated with 'printing money' (the process whereby the government or central bank buys assets from the private sector by creating money) more heavily than the benefits of security. At this stage government bond yields will rise.

Credit spreads will eventually fall provided we avoid the cataclysm that is now priced in. The order in which these events unfold, and the magnitude of the change in perception will determine the returns achieved in the credit markets. The likelihood is that there will be an opportunity to benefit from falling spreads before inflation worries undermine the returns from all bonds and means great care should be taken in balancing these competing views in fixed income portfolios.

Currency markets have also had some extreme moves in recent months.

Sterling has been the main casualty as investors sensed that the UK economy was likely to be one of the worst affected by the financial crisis. Certainly, public sector finances are set to deteriorate sharply, but it is as well to remember that our national debt is still relatively low and that our economy is more flexible than in some of our main competitors.

— Ken Forman

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