Return to normal will be worth wait

Central banks failed to calm sentiment as forced selling and fear continue to drive markets. But as competition dwindles, strong players will flourish and patience will be rewarded.

Equity markets are in freefall. In the week to October 10 the S&P 500 index fell by 18.3%, the largest weekly decline on record. As of October 15 the MSCI World October index was down 41%, worse than the 32% fall low point in 1974, according to Datastream. The immediate cause of the acceleration to the downside was the failure of Lehman Brothers. The hope of the authorities that counterparties had had time to prepare for the demise of a large financial institution and that the bigger threat was the “moral hazard” of not allowing Lehman to fail was misplaced. The result caused an even greater desire to hoard cash.

The market declines have stimulated some dramatic policy responses, including the first co-ordinated interest rate reduction led by America’s Federal Reserve. The half- point move was joined by the People’s Bank of China, which cut rates by 27 basis points. As yet, even the promise to make an unlimited quantity of dollars available through the central banks and the announcement by the Fed that it will buy commercial paper direct from any issuer that is unable to find a buyer in the market has done little, if anything, to calm sentiment. Notably, the dollar continues to rise in value as the normal free flow of currency in the interbank market grinds to a halt. This shortage of cash is reflected in the persistence of high interbank interest rates, high and rising corporate bond yields and mortgage rates and rising real yields on government bonds.

Given that markets are being driven by forced selling and fear as the financial system deleverages, short-term forecasts as to which policy initiative will prove to be sufficient to stem the panic is of little value. This is a dangerous environment and the longer it persists the greater the risk of a negative market and economic outcome.

Policymakers have rapidly moved from dealing with financial problems on a piecemeal basis to viewing the turmoil as systemic. Further and more extreme policy initiatives are likely, as Jean-Claude Trichet, the president of the European Central Bank, observed in a speech in New York on October 15: “This is time for immediate action and not for eloquent rhetoric”. It would not be a surprise to have seen larger, co-ordinated interest rate reductions between the writing of this note and its publication.

Regardless of how quickly the authorities resolve market concerns, the economic impact of events this year are carved in stone. Global growth is likely to be much weaker than it has been in the past five years as the process of deleveraging in the West continues. The decoupling of the developing world from this has been disproved. Yet where economies such as America and Britain are more likely to see “bath-shaped” growth profiles, the prospect for many parts of the developing world is of a more normal inventory/investment driven, V-shaped downturn.

Inflation fears that dogged markets earlier in 2008 are unlikely to reappear for many years. The greater concern after a period of global growth led by investment in global infrastructure and productive capacity will be falling prices. This will be a significant positive for many economic participants/equity sectors and companies that have struggled in the past few years asrising costs have squeezed disposable incomes and profit margins. This is likely to prove to be as important to investors as recognising that the beneficiaries of the Nasdaq collapse post-2000 were those most geared to low interest rates (while official interest rates are likely to remain low for an extended period once again, it is less clear that these rates will be transmitted to the wider economy and hence is likely to maintain downward pressure on prices).

Businesses and consumers that are not over-extended will take market share from those who are. Where in the past the easy availability of credit – and the private equity bid – lifted all participants, a tighter credit environment will see far greater differentiation between winners and losers. While media commentary will focus on the traumas of those most adversely affected by this new environment, the beneficiaries are likely to continue to see conditions improve as competition diminishes. The widening interest margin available to British banks is likely to be one example of this lower level of competition for deposits following the failure of the Icelandic banks.

Equity valuations are cheap. The 11.2 times historical earnings for the Datastream non-financial, non-resources world equity index is the lowest rating since the trough in 1984. Even with a difficult economic outlook, this compensates for a high degree of earnings risk.

Though there is little experience on which to draw as to when liquidity conditions might improve, for those able to be patient the return to more normal market conditions – even if these are different from the norms of the past decade – should prove to be rewarding.