On a recent marketing trip to the South West of England we spent a lot of time running through how we felt the autumn's financial market turmoil might impact on global economic activity and long-term financial market returns.
The conclusion was, perhaps unsurprisingly, that there would be an obvious negative impact on global and particularly developed economy activity and that in future financial market returns would more closely match underlying economic reality than perhaps they had over the previous four years. It is now time to look at the big picture for 2008 in more detail.
We believe that global growth will slow in 2008 and that that slowdown will be driven by weakness in the US. We think it very possible that the US could experience a technical recession over Q4 2007 and Q1 2008, however, as the impact of earlier Fed rate cuts begin to work their way through, coupled with a dwindling negative impact from the residential property crisis, growth should pick up as the year progresses.
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Furthermore (and unlike consensus) we do not completely believe in the so called BRIC (Brazil, Russia, India and China) economies' ability to decouple from the US slowdown now at hand. Thus we anticipate slower growth from these countries too and perhaps importantly, without much of a rebound in 2009.
We expect a sharp slowdown in UK activity and believe that official growth forecasts at c2.0% for 2008 are too optimistic. Furthermore, we are unconvinced by this country's ability to bounce back strongly in 2009 without the stimulus provided by sharply lower short-term interest rates which we are not sure the Bank wants to provide.
Equally, eurozone growth is set to slow next year too; however, investors are likely to focus on the scope for a recovery in 2009. At present this looks hard to predict with any great certainty, particularly given the European Central Bank's (ECB) unwillingness to be goaded into cutting base rates at all.
Despite the equity market turmoil experienced over the autumn we are not expecting a complete collapse in global economic activity (although a longer and deeper recession in the United States is a real possibility it is not our central projection).
We should point out, in the context of our recent thoughts regarding the adjustment process by which a US trade deficit of c6.0% of Gross Domestic Product (GDP) becomes a more sustainable deficit of c2.5%, that the improvement in the US trade balance will come through markedly lower imports, with negative implications for exporting nations'
growth prospects.
Economic decoupling has not helped equity markets
From a purely economic perspective 2008 is likely to witness something of a global decoupling. Western economic growth is expected to fall pretty sharply while growth amongst the BRIC countries holds up relatively well. Over 2007, synchronised global growth contributed to a strong performance from emerging equity markets.
It remains to be seen just how successfully activity in the BRIC economies will hold up in the event of a very pronounced and prolonged US economic slowdown, however, our sense is that if the US slowdown is short-lived then BRIC economies might survive relatively unscathed.
We must emphasise that a US recession is not our base case yet, however, the percentage probability continues to rise and is currently standing at just below 50%, compared with around 30% this time last year. A very large number of economic indicators are pointing to a marked quarter on quarter slowdown between the latest upwardly revised annualised growth figure for Q3 and what we believe lies in store for Q4 (c0.5%). Given the importance of the US as an export destination for many countries, we expect an adverse global impact elsewhere.
A quick glance at 12-month forward price earnings ratios by equity market illustrates how much investors have taken the idea of global decoupling to heart. India trades off 20x, China 19.5x, the Philippines and Indonesia c15.8x. The first two are close on double where European equities are trading so why should investors pay up for direct exposure to these vulnerable economies when one might be able to pay around half the price for European multinationals with significant Asian exposure?
Anybody who doubts that a prolonged period of economic dislocation is round the corner, but who suspects that Asian growth might slow in response to slower US growth, would probably be well advised to invest for convergence in economic performance over 2008/09 rather than further divergence. As a base case scenario this looks pretty compelling.
We have been very negative on the dollar for a long time now. We are not alone. To our ranks two new high profile celebrities have been added; rap artist Jay-Z and Brazilian supermodel Gisele Bundchen. Both have opted to be paid in euros rather than dollars, despite the latter's 30% trade weighted fall over the past five years.
Elsewhere the Chinese state media continues to respond aggressively to continuous talk of protectionism on Capitol Hill by referring to the country's apparently vast store of dollars as its economic "nuclear option" and the Gulf Co-Operation Council has recently debated the possibility of reallocating reserves to the euro.
The dollar is now strongly undervalued against other developed currencies; however, the trade deficit adjustment process is likely, if it follows the normal path, to result in a more prolonged period of slow growth and currency weakness.
This and further Fed rate cuts leave us with no burning desire to forecast a trade weighted recovery, although the UK economy's deterioration next year may mean that sterling performs even worse than the dollar and that cable claws its way back to c$1.90 over the next twelve months.
Outlook for equities in 2008
If 2008 is to be a year of slower global growth and a year in which Western and Asian economic growth rates converge (if only on the basis that growth in the latter slows more quickly) then what are the likely implications for equity markets?
The honest answer is that weakening economic momentum does not bode particularly well for equity markets and that 2008 could prove to be another year in which bonds perform relatively well.
Even more significantly, we look for only a partial recovery in economic activity in 2009. This suggests that the trend in corporate earnings expectations (an important forward indicator) which has been unremittingly negative over the autumn, has only very limited scope to recover strongly over 2008.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
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