Commentary by Mike, Turner, Aberdeen's Head of Global Strategy & Asset Allocation
The stakes could hardly be higher at the moment. This is a market being driven by fear as much as hard facts. The failure of the political and monetary establishments to agree what needs to be done has had a massive impact on market sentiment, and risk appetite has fallen into the panic zone. But because there is little evidence to justify the swiftness of the sell-off, and because there is still a reasonable chance of a modest acceleration in growth in the second half of the year, we would not be surprised to see the markets stabilise in the next fortnight.
The speed of the market decline has been breathtaking, exacerbated by technical aspects within the derivatives market - namely the unwinding of volatility exposure. Nevertheless, the catalyst was anxiety about the creditworthiness of developed countries, given the implicit lack of political cohesion on both sides of the Atlantic.
Policy responses will be key going forward, both in terms of containing the stress now appearing within money markets, and the ability of governments to tread a fine line between austerity and growth in order to maintain credit ratings. The most immediate issue lies within the euro-zone, and France's AAA rating has now come under scrutiny. Most significantly, there are signs that the markets are beginning to price in the financial implications of rescuing the euro.
Consequently, asset price performance has become a near term threat to the global economy with investors now fearing the implications for capital ratios within the financial sector. A sustained selling of bank stocks has ensued, and ironically a rush to safe-haven government bonds has counteracted the very threats that investors were worried about in the first place.
However it now appears more difficult to obtain funds within money markets and this has manifested itself in rising money market rates. This cycle has to be broken, as there are signs that the financial crisis of 2008 is repeating itself. The Federal Reserve's commitment to maintaining rates at their current low levels through mid 2013 is a good start, but a more concerted international effort needs to take place. Japanese currency intervention and Swiss National Bank easing will help but coordination is still needed.
At least markets are pricing in a significant element of this deteriorating environment. Risk appetite on some measures is lower than it was at the height of the crisis in November 2008. As a contrarian indicator, this suggests markets could be oversold - especially as there is a reasonable chance that modest growth in the second half will rescue us from a ‘double dip' recession.
In support of this, the recent fall in oil prices should reverse the negative impact on consumption, and the latest Japanese industrial production statistics demonstrate that supply chain disruption may be easing. Falling US mortgage rates may also lead to modest refinancing putting cash back into the pockets of US consumers, whilst the expiration of accelerated depreciation allowances for fixed investment could boost capital expenditure in the months ahead. Global trade may not be suffering too badly either, with China producing the largest trade surplus in two years in July.
However, with confidence remaining fragile, hiring remains sluggish in the US, and personal sector deleveraging will continue to create shorter business cycles than we have experienced in the last two decades. That is why the immediate policy response is so important.
But if we are right, then this market is providing investors with a buying opportunity in the short term, with some valuations getting near to extremes. Stocks are at historically low P/E ratios (although price
to book values are not as depressed), and dividend yields should provide some support. Bond-equity yield ratios are also now above 1 in most cases, with stocks now yielding materially more than bonds.
The fact that the Australian banking sector is yielding 9%, despite being one of the least affected banking sectors in the world, seems to us like the market is discounting a massive fall in profits.
So, while the focus on indebtedness is not going away, and deflation remains a threat, the market is acutely aware of this and has scope to stabilise at these lower levels, even if there is likely to be sustained volatility while it does so. However, as we head into 2012, the fate of the global economy depends more than ever on achieving the correct policy response.
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