Market Outlook
Fall 2008
One year after the credit crunch began, market conditions remain deeply depressed. What began as a valuation problem in the sub-prime housing and securitization market has touched virtually every lending and borrowing pocket of the financial system.
ECONOMY EXPANDS BUT GROWTH DEFINITELY SLOWING
Economic growth so far this year has shown surprising resilience, defying even the loftiest expectations. There’s no question that the credit crisis remains a serious challenge to the economy. While a negative real fed funds rate is accommodative, borrowing costs, credit availability, asset prices, risk preferences and the capital needs of financial intermediaries are all imposing varying degrees of restraint. At the same time, an end to the crisis would pose substantial risks for fixed income investors – including those who have ejected corporate credit from their portfolios to weather the current storm. In the U.S., strength in the first half of the year as well as further improvement in the terms of trade leave us comfortable with our 2008 growth forecast of 1.75%. We have cut our 2009 forecast to 1.5% as the economy passes through a brief and mild recession in the fourth quarter of this year through the early months of 2009. We expect Canadian growth to slow to 1% this year before gaining traction late next year.
ENCOURAGING SIGNS ON THE INFLATION FRONT
On balance, even as reported inflation remains high, there are encouraging signs that one of several key threats to the U.S. economy is beginning to subside. The retreat in oil prices has begun to steady the U.S. dollar, perhaps signalling a broader lift in investor confidence that will be needed to put the economy back on track in 2009. With commodity prices likely past their peak, headline inflation rates are set to fall sharply by year-end.
CENTRAL BANKS STILL HAVE FIREPOWER
Recognizing the scale of threat posed by sliding real estate prices and negative feedback loops within the financial system, the Federal Reserve has been swift and deliberate. Short term interest rates have fallen 3.25% and the domestic money supply is growing rapidly. Systemic risk is being mitigated with a variety of responses ranging from broadening the types of institutions granted access to the Fed’s discount window and expanding acceptable collateral to forcing bank shutdowns, mergers or providing emergency backstop funding.
In Europe and the U.K. too, where the credit crisis is intensifying, central banks and government agencies are now taking aggressive action to limit the fallout. The Bank of Canada is likely to stand pat with a small bias to cut rates as weak U.S. demand coupled with a stronger Canadian dollar increase the drag on GDP from deteriorating trade conditions.
BONDS OVERVALUED; YIELDS SHOULD RISE AS CREDIT CRUNCH ABATES
Fuelled by a flare-up in concern over the health of the financial system, massive risk aversion and downward revisions to global growth, bond yields have plunged over the past quarter. Valuations remain at extreme levels, lying below their equilibrium bands in all major regions. In the U.S., the drop in yields is the second largest on record through any easing cycle since the early 1950s and implies a much deeper and prolonged slowdown than is likely to emerge. As the credit crunch begins to abate, risk premiums normalize and the economy responds to lower rates, bond yields should move to levels consistent with moderate growth, leaving them vulnerable to significant upside pressure.
STOCKS SHOW SOLID VALUE AND POTENTIAL
The crisis environment of the past year still shows few signs of clearing, so the way ahead for stocks is unusually murky. Nevertheless, valuations based on normalized profits and P/E ratios reflect a level of pessimism that hasn’t been seen since the great bull market began in the early 1980’s. As we view the recent spike in inflation to be transitory and primarily the result of sharp increases in energy prices, which have now reversed, winning conditions are very much apparent with stocks far below fair value. Risks are evident, but so is the potential for superior returns. At a minimum, as confidence is ultimately restored, stocks should return to fair value, a climb that would produce double-digit returns.
