Stout anchors for stormy waters

Now is not the time to worry about every price movement. Better to focus on key factors such as the global nature of financial problems and the effects of currency changes on investment prospects.

Now is not the time to worry about every price movement. Better to focus on key factors such as the global nature of financial problems and the effects of currency changes on investment prospects.The global equity markets are under extraordinary stress. Sectoral volatility is rising and many market participants are confused and disorientated. This is the nature of a bear market. They are always horrible.

At times like this, rather than worrying about every movement in prices, it is worth reminding ourselves of what we know – key facts that should act as anchors in a stormy environment.

The first fact is that the prime mover in the world continues to be the credit crisis. The slowdown was led by the credit crisis and the global economy is likely to be led out of the slowdown by the resolution of it. Financials and banks in particular are still operating in deteriorating conditions.

There remain major problems for the sector in terms of capital adequacy, and the next few months will be a critical period. Extraordinary though it may seem, in many ways we have passed the easy bit of the crisis. The initial losses were partially absorbed by the banks’ capital and many sovereign wealth funds were keen to contribute. The writedowns and provisions are rolling on, but there is little excess capital left in the banking system and sovereign wealth funds are nursing large losses. These funds will need to be given some compelling offers to lure them back. The cost of bank capital is still rising.

The Fannie Mae and Freddie Mac development is positive and so the markets’ reac- tion has been sensible. The American government has effectively nationalised these entities. This removes one huge cloud of uncertainty for the financial markets.

But potentially the more significant event is the new window created for the Federal Loan Housing Board. The board can borrow directly from the Federal Reserve, which is helping to cheapen borrowing for the American banking system. This is another positive, but it is not a comprehensive solution because it does not address the issue at the heart of the problem: bank capital. It helps short-term funding, but the capital adequacy issues are more important.

The second key consideration is that the world is more intertwined than ever before and there are few areas of resilience. The weakness seen in America is spreading to the rest of the world, and now Germany – strong in the first quarter – has hit problems: recent data on retail sales and industrial production look fairly grim. Some better news is coming out of France, where Nicholas Sarkozy’s reforms are making progress, but the whole of the eurozone is weak.

It is clear that the European Central Bank (ECB) is going to be able to cut rates in 2009. Inflationary forces have dissipated sharply, which will free the hand of the ECB enough to move. So the European forecast is likely to be a recession in many countries, but it ought to be fairly short-lived in the main economies of the eurozone. It looks as though Europe will be operating at different speeds in different areas, with Spain, Ireland and Italy likely to stay in the quagmire much longer than France and Germany.

This will be a tougher challenge for the ECB to manage than its experience in recent years. It may even prompt some populist politicians in the weakest economies to question the value of a single currency. This will be a futile endeavour, since the costs of leaving the eurozone will be far higher than the pain of staying put, but it may appeal to some of the electorate and therefore is likely to be heard in some quarters.

Italy, for example, has often devalued in times of economic crisis, and without this mechanism, the only option is genuine structural reform. This is a bitter pill to swallow for the country. There is no evidence of reform on the horizon, and even if implemented, it would take a long time to work. But it is the Italians’ only real hope to revitalise their economy in the long term.

In terms of global economic growth, China will play the most important role in the fourth quarter. The American tax cuts have been used up. This means the post-Olympics Chinese stimulus package is critical. China’s economy is slowing down fairly sharply and a burst of stimulus could have a big effect on markets. It is difficult to judge how effective the package will be.