Investment View

Monthly Investment View Update - August 2008

As part of our continued commitment to keeping you informed on the outlook of the global investment market, we've developed this new section on our website to keep you updated. Featured on this page, you'll find a global economic overview and commentary on our overall investment strategy.

With investor sentiment having tumbled in recent weeks, equities seem ripe for a rally...

In recent weeks, fears of financial Armageddon have stalked markets for the second time this year. This was as concerns about the solvency of Fannie Mae and Freddie Mac forced the US authorities to make it clear that they will stand behind the two mortgage giants if necessary. As a result, our investor sentiment indicator plumbed depths last seen at the time of the Bear Stearns bailout in mid-March. Together with the fact that fund managers are much more underweight equities than they were during the last bear market, this set the equity market up for a tradable rally of 6%-12%. To get to the upper end of that range, the S&P 500 would have to overcome strong resistance around 1300 - 1310.

…but a gloomy economic backdrop suggests that this will be a short-term bounce.

Our current thinking is that this rally - like those that started in January and March - will prove to be a short-covering rally in an increasingly long-in-the-tooth bear market, rather than the start of a new bull market. We expect equities to slip back again in August, as the boost from the fiscal stimulus fades and investors refocus on the poor underlying health of a US economy in the grips of a credit crunch.

That's not to say a more positive environment for risk assets is off the cards - at worst, it is just delayed.

But it is important to keep developments in perspective. Our central scenario for 2008 envisaged a move out of stagflation and a transition to a more positive environment for risk assets around the middle of this year. Given that we are only a few weeks into the second half, it seems too early to declare this call off track and to rule out an equity rally in the final months of the year. At worst, the global economy’s transition out of stagflation - and with it, a more positive environment for risk assets - has been postponed. It has not been cancelled.

Slowing global growth should prevent a re-run of the 1970s wage-price inflation spiral...

We do not subscribe to the populist view that the economy is reliving the 1970s. Admittedly, the current environment does have echoes of that era, particularly in developing economies. But to return to the double-digit inflation rates seen in some developed economies in the 1970s would require a wage-price spiral to break out - and we do not expect that to happen. The ongoing slowdown in the global economy, resulting from the twin shocks of high energy prices and the credit crunch, will keep wage pressures under control.

..and, as investors concede this, equity valuations should appear more attractive - spurring a more sustained rally. But this is contingent on a lower oil price...

An acceptance from investors that inflation will peak out and that this is 'just' another deleveraging recession - rather than a return to the 1970s - would cause them to view low PEs as historically attractive, rather than as compensation for the risks associated with unexpected inflation. This would sow the seeds of a more sustained equity market rally. But for that to happen, the recent falls in the oil price need to hold or - better still - continue. That would untie central bankers’ hands, allowing them to focus on fighting the deflationary effects of the credit crunch. This would steepen the yield curve, taking some pressure off the beleaguered financial sector.

…which can only stem from demand also slowing in the developing world.

Why might upward pressure on commodity prices ease? We think this will happen as the slowdown in demand already evident in developed economies spreads to the developing world via reduced import demand, particularly for consumer goods. Moreover, oil consumers will be forced by a combination of higher prices and legislation to reduce their usage.

The content of this article does not purport to provide any financial, investment or professional advice and should not be deemed to constitute the offer or provision of financial, investment or other professional advice in any way. Before contemplating any transaction you should obtain advice from a qualified expert.