Downswing stokes cautious stance

Tighter credit availability and a deteriorating housing market will hit American growth – and the British economy is also set for a slowdown – so investors should take a cautious approach.

A downswing of the global economy is underway, despite the strength recorded in the third quarter. What has changed and what are the implications for financial markets?

One significant change has been the run up in energy prices, with Brent oil for early delivery increasing from $71 in August to $95 recently. This may simply reflect the third quarter surge in global activity. But a more sinister explanation is that the immediate energy saving impact of earlier price rises is fading. With supply inelastic in the short term we may be seeing something of an energy market crunch with adverse implications for global growth.

However, the major change in recent months is that the problems in the American subprime mortgage market have fed through to a general repricing of risk from unusually low levels. In itself this is not necessarily a bad thing. But the immediate problem is that the flow of credit in financial markets has been seriously disrupted, with lack of transparency creating uncertainty about where losses lie.

To the extent that losses are acknowledged, the capital base of the banking system is eroded, reducing the scope for new lending. The key for the world beyond financial markets is credit availability. And we know from official surveys that this has deteriorated significantly, not just in America, but also in Britain and the eurozone.

America remains at the centre of worries, not least because the housing market continues to deteriorate at a disturbing rate. This is feeding back to problems for the banks and also for Freddie Mac and Fannie Mae, the enterprises that lie at the heart of the prime mortgage market. It looks likely that American residential investment will fall right back from the 6.3% of GDP reached in the second half of 2005 to a low similar to the 3.25% troughs recorded in 1982 and 1991 (see graph).

In addition, credit availability effects are likely to curb American business investment, leading to weaker growth of employment. But the big question is the extent to which households adjust their overall spending behaviour in the face of the housing mess. As yet there has been surprisingly little impact but a significant consumer retrenchment remains a risk. We look for American growth to run at only a 1.8% pace in 2008, the slowest since 2002, with risks to the downside. We continue to see a renewed recovery in 2009 as housing market activity bottoms out, but project growth of only 2.5% that year.

Our forecasts for other advanced countries are also reduced (see table). Britain finally appears to be running out of luck as the twin weaknesses of an overvalued housing market and heavy reliance on the financial sector are exposed. In the eurozone, economic activity is decelerating in response to higher interest rates, tighter bank lending standards and the strong euro. In Japan, new building regulations have led to a sharp dip in construction activity. This should prove temporary but more worrying is the lack of buoyancy of household incomes and spending.

By contrast, our outlook for growth in the emerging and developing countries is still robust, indeed stronger than we suggested in July. This has implications for our view of inflation in the developed countries: weakening activity may put some downward pressure on ‘core’ measures of inflation but global competition for resources will underpin overall inflation measures, which include food and energy.

Putting everything together, we see most central banks cutting interest rates in the face of sharply weakening activity. The Federal Reserve has already cut its key rate from 5.25% to 4.5%, and we expect a further fall to 3.75%-4.0%. In Britain we expect that the monetary policy committee will cut from 5.75% to 5.0% over the next six months and perhaps further in 2009. In Europe, we see the European Central Bank reducing its key rate from 4% to 3.5% by the end of 2008. Finally, in Japan the likely direction is still up but the pace of “normalisation” from the current 0.5% will be slow.

However, this does not make government bonds particularly good value, following their strong run. In particular a yield below 4% on 10-year American treasuries implies poor value against a model of long-term inflation expectations, pointing to a steeper yield curve on a one-year view.

Other major bond markets offer better underlying value but Britain and Japan, like America, look overbought on a shorter-term (three-month) view. Meanwhile, we remain wary of corporate debt given the extent of uncertainty over the economic outlook. Finally, equities in developed markets may look attractive on most measures relative to bonds but the possibility of a squeeze on corporate margins calls for a degree of caution.