|
After a turbulent January, the global economy looks set for a rocky ride in 2008. But for investors with enough cash in their portfolios this year will offer many opportunities to pick up undervalued assets. Equities in developed markets look particularly cheap.
While Merrill Lynch believes that the US is already in recession, other parts of the world are still enjoying good growth. Nonetheless, lower corporate profitability, inflationary pressure, decreased liquidity in international markets and the slow pace of interest rate cuts are likely to spell modest returns across many asset classes.
In our view the most likely scenario is that the US recession will be offset by good growth elsewhere in the world. We remain cautious. We will also stay on the lookout for opportunities to buy into any significant weakness in the market. At the same time we are in no mood to structurally add risk in our portfolio.
Opportunities will crop up for private investors to buy undervalued assets. The cheapest asset class is equities, raising the prospect of decent buying opportunities for investors with cash in their portfolios.
Nonetheless, even the best-performing equity markets are expected to offer modest returns. Developed market equities, however, are likely to outperform equities in emerging markets. This is underpinned by the expectation that interest rates will be cut sooner in developed markets. Valuations in developed markets look more compelling than in emerging markets.
Merrill Lynch remains positive on countries in the GCC.
Value
Globally, opportunities are starting to crop up for brave investors. Value is emerging, for example, in the bonds and shares of companies in financial services and UK property companies. Some UK property firms, trading at a 40-50 per cent discount to net asset value, look attractive.
Japan, where a massive recession has been priced in, also looks attractive as we do not expect a major downturn to materialise there. Japan, in fact, is enjoying sustained employment growth, although wages remain weak.
Investors can also expect further good performance from soft commodities. As more governments encourage the use of renewable energy and the switch from fossil fuels to green energy, the demand for bio-fuels is accelerating amid concerns about climate change. Demand for corn, soybean and wheat will remain strong even in the face of a downturn.
The whole world has experienced a major expansion in the availability of credit. This has been followed by a significant retraction in the availability of cheap loans. Banks have become more risk averse in an environment where $700 billion of sub-prime debt sits at the foot of a $10.7 trillion pyramid of debt.
Liquidity in international markets fell during the last quarter of 2007, slowing growth and limiting returns across asset classes. This weakness is likely to linger well into 2008 with inflationary pressure limiting the ability of central banks to aggressively cut interest rates.
Looking ahead, global economic growth will struggle to pick up steam without the support of broad interest rates cuts. The decision by the Federal Reserve to cut its federal funds rate by 75 basis points to 3.5 per cent delivered what the economy needed. But while the Fed cut was helpful it will need to follow up with further rate cuts. Crucially, other central banks will need to follow suit to ensure markets enjoy a prolonged recovery. The view is that the Bank of England and Bank of Canada will also continue cutting rates. Any move from the European Central Bank (ECB) will depend on economic news from the euro zone in the coming weeks.
Economic pain
It is important to remember that cuts in interest rates take time to work. While cuts in interest rates will alleviate some of the economic pain, the huge amount of household debt in the US will take some time to unwind. The reality is that US consumer debt has never been higher. Based on past experience, we should also expect further pain as a result of the US housing crisis and sub-prime mortgage lending.
US industrial confidence is still sliding. The Philadelphia Fed manufacturing index dropped to -20.9 in January from -1.6 in December, a level that in March 2001 presaged the first month of recession.
President George W. Bush has responded to economic concerns by outlining a $140 billion package of tax cuts, a combination of tax relief for individuals and tax breaks for corporations. According to press reports the White House is considering tax rebates of $800 for single tax payers and $1,600 per household. That would leave about $25 billion in tax relief for corporations.
Our hope is that reasonable growth in other parts of the world will offset the recession in the US to some degree. David Rosenberg, chief economist for North America at Merrill Lynch, has forecast that Fed funds rate will fall to one per cent. At the moment we would not make this a central scenario. If Rosenberg is right we are facing a prolonged period of turmoil in financial markets.
The Fed and the US government will try to bolster confidence in the economy. Sovereign Wealth funds - newly prominent investors on the block - are also playing a central role, buying cheap assets which offer long-term returns.
Continental Europe, initially regarded as immune to sub-prime concerns, is also on a slowdown watch. Consumer confidence and retail sales have softened, probably in reaction to big hikes in food and oil prices. The confidence of German financial analysts is at its lowest point in 15 years and industrial activity, in places like Italy, has stalled. There is little prospect of an ECB rate cut yet, reducing the risk of an ill-timed hike in interest rates for Eurozone countries like Germany, France, Italy, Spain and Ireland.
All the benefits of interest rate cuts will be undone if the financial system suffers further stress. The markets will remain fearful of more bad news until the full earnings reporting season for financial companies has come to an end and they have identified their credit related write downs. Reduced liquidity in global financial markets could also put pressure on the value of property, metal prices and emerging market assets.
Oil and gold
Merrill Lynch believes there is a risk of a drop in gold and oil prices later this year. If high gold and oil prices persist in the short term they could encourage increased supply and dampen demand in the second half of 2008. India and China, which account for 50 per cent of the growth in demand for oil, will struggle to pay $90 a barrel.
We predict an average gold price of $750 in 2008 and an average oil price of $80 per barrel. We may finally be seeing demand for oil drop in reaction to higher prices.
In the currency markets, Merrill Lynch believes that the greatest scope for shock stems from possible de-pegging of certain currencies against the dollar. Inflationary pressure may force some central banks - such as in the Gulf - to either reset their pegs or to allow a free float.
The dollar appears to have suffered its biggest decline in this economic cycle but sterling could be vulnerable. A downturn in the UK's housing market could lead to slower growth and lower interest rates, in turn prompting sterling to fall against the dollar and the euro.
The yen could become a safe haven given the risk of higher interest rates against a backdrop of weaker global growth.
How events play out in the global economy in 2008 remains to be seen. Market concerns about a more significant slowdown outside the US are increasing. Even in China there is potential for a slowdown.
Our "muddle through" scenario - in which in the US recession is offset by good growth in other parts of the world - is still our favourite, with a probability of 45 per cent. We view the risk of a full blown global recession as high as 35 per cent. Our third scenario is one in which the Federal Reserve takes a risk with inflation and cuts rates aggressively to stimulate growth but stores up for the future by stoking inflation.
We give this a 20 per cent probability. We believe that the "muddle through" and "Fed risking inflation" scenarios would lead to a rebound in equities later this year. Be vigilant for such a moment.
- The writer is chief investment officer, Merrill Lynch Global Wealth Management (EMEA).
|
