Over 2008, the liquidity crisis – which started in mid-2007 in the markets for commercial paper and asset-backed securities – began to hit the broader economy hard, with the US, the eurozone, Japan and the UK all contracting in the second half of the year and emerging market growth also beginning to falter.
The main question facing investors in 2009 is how far this feed-through from financial markets will continue and, in particular, whether the asset price deflation of 2008 will become embedded in the broader economy as general price deflation. At this stage of the cycle, the key to the economic and market outlook is the direction and effectiveness of fiscal and monetary policy.
The financial crisis will affect the broader economy via a rise in the household net savings rate (how much households are saving overall, minus their borrowings). We expect net savings to rise during 2009. Usually, the forecasting model we use is a reliable guide. However, at times of financial stress, such as the mid-1970s and early 1990s, the savings rate generally rises far more than the model predicts. That's because households not only ask for less credit but also find less credit made available to them – they become credit-constrained.
Those economies that had previously enjoyed growth funded by a rapid expansion of credit – such as Spain and Ireland and, to a lesser extent, the US and the UK – are especially exposed, but tighter credit conditions and higher unemployment are set to drive up savings rates everywhere.
As a result, we expect growth in most developed economies to stay negative until the third quarter of 2009 at the earliest and below the trend rate until the end of the year, with Europe and Japan lagging broadly six months behind the US and the UK somewhere in between.
We also believe that the rise in developed countries' savings rates will slow during the second half of 2009 as lending conditions loosen in response to policies implemented to repair banks' balance sheets and reopen credit markets. Later in this phase of the cycle, equities should outperform bonds, as the economy heads into recovery.
UK and US household net savings rate, 1960-2008
However, savings rates in the US and the UK are at historically low levels. The mechanism which enabled this drop in savings – notably, the mortgage securitisation market – is unlikely to return to peak volume levels for many years, if ever. So, although the rate of increase in savings may slow later in 2009, thus enabling a return to positive growth, it could continue on an upward trend for many years or even decades. If so, the current financial crisis would represent a turning point, rather than a typical recession.
Hence, a combination of measures is needed to address the inter-linked problems of the banking crisis, the liquidity crunch and the associated recession. Further bank bail-outs, continued low interest rates and looser fiscal policy are all likely to feature. In particular, a series of initiatives are expected from the newly elected US Congress, and the scale of the fiscal boost, in conjunction with other measures, should underpin positive economic growth in the second half of 2009.
Market Outlook
For many investors, the key question now is: when is the right time to re-enter equity markets? After equities’ sharp falls in 2008, valuations have improved significantly. According to our macro-economic scenario, profits for 2009 could be downgraded further. But buying into equities is a claim on long-term future profits, not just on next year’s earnings. For investors with an investment horizon of three years or more, current valuations should offer long-term support.
Looking at the eight US recessions of the past 50 years, macro-economic indicators such as the ISM and unemployment data have provided useful guidance for market bottoms. Equity markets have tended to hit their troughs when the economic climate has reached very depressed levels, as now seems to be the case. Of course, this recession is clearly abnormal, with macro-economic conditions as bad as most investors have ever seen. However, in such exceptional circumstances, where markets are driven by fear, traditional fundamental triggers such as valuations and economic data offer little help for short-term market timing. Given the extreme volatility in the markets, it seems imprudent to try to anticipate rebounds.
In this climate, investors need to understand their own tolerance of risk. Those who can accept more risk may be able to capture the early stages of any market rebound. However, we believe that investors with a low risk tolerance should wait until a more normal phase of the investment cycle before adding to positions in riskier assets, such as equities and corporate bonds. We would identify the three most important such market-based indicators as: a substantial reduction in equity volatility; higher yields on two-year bonds; and lower credit spreads.
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