How long the bear market – and what are the risks?

More than any time in history mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray that we have the wisdom to choose correctly. Woody Allen

Key points

• While further falls in share markets are likely and the next six months will remain volatile, we expect the US downturn and slump in shares to be relatively short lived. Things should be on the mend in the second half.
• The main risks are a continued problem with global inflation (which we think is unlikely) or a drastic unwinding of debt levels in the US and elsewhere (which is a greater risk and should be watched closely).

Introduction

Much of the commentary regarding the US economy, the falls in share markets and US policy makers moves to do something about it, make the outlook sound like the Woody Allen quote above. Some see a long and severe downturn as layers of debt are unwound. Others see the US Federal Reserve (Fed) sewing the seeds of inflation. Some see both (i.e., stagflation).

But is the outlook that bad? This note looks at the wall of worry, or risks, now facing shares. Our conclusion remains that while shares are likely to have a rough ride over the next six months or so, we don’t see an extended global downturn or an extended bear market in shares.

Our view

The cyclical bull market in shares that got underway in March 2003 now looks to be over. Many share markets had falls greater than 20% from last year’s highs and the pattern of rising highs and lows in share prices that normally characterises a bull market has been broken by the sharp falls in share markets so far this year. The question is how long will the slump last? Of course, much depends on the US economy. Our assessment is that:

• The US economic downturn will be relatively mild: the Fed is now moving quickly to reflate the economy; fiscal stimulus in the form of personal tax rebates and tax breaks for business to invest will also help boost growth; the corporate sector is in fairly good shape; and the rest of the world is generally solid, which along with the lower US dollar (US$) will help US exports. It’s also worth noting that while credit markets are still in dire straits, short-term money markets have improved dramatically with interbank lending rates falling dramatically since the coordinated intervention by global central banks last December. There are also signs that the housing market is getting close to a bottom, although US house prices clearly have more downside.
• None of this is to deny that the news out of the US will get worse before it gets better, particularly for consumer spending. However, it suggests that a relatively mild six to nine month US downturn is likely. Through the second half of the year the US outlook is likely to be improving.
• Against this US backdrop, global growth will slow dramatically this year, but it is unlikely to collapse. Japan is probably already in recession, but Europe and emerging markets are likely to slow but not collapse. While leading indicators for developed countries are in negative territory, they remain solid in emerging countries.

Source: Thomson Financial, AMP Capital Investors

• Given the likelihood of further bad news on the US/global economy and the flow on to profits and ongoing problems in credit markets in the short-term, share markets are likely to see further downside. However, the bulk of the damage should be behind us (with major share markets having already had 20% or so falls) and the trend should improve through the second half of the year. In this regard:
  - share valuations are now very cheap with Australian shares trading on a forward price to earnings ratio (PE) of 12.8 times, which is well below the average over the last decade of 15.3;
  - at some point over the next six months shares will start to look forward to better global growth ahead and rally into year end; and
  - investor sentiment towards shares has become very bearish which is normally a positive sign from a contrarian perspective. See the next chart which shows a composite measure of various surveys of US investor confidence – which is now pushing extreme lows.

Source: Bloomberg, AMP Capital Investors

• Given the difficulty in timing market bottoms, the best approach is to average in over the next six months.

The wall of worry

None of this is to deny the degree of uncertainty now facing investors. There are now a number of worries. One of the best summaries of these was in an article by George Soros in the Financial Times last week. In essence, the two key arguments on the downside are that on the one hand, the Fed’s aggressive moves risk fuelling inflation, and on the other, they won’t work in jump-starting the US economy because the US faces a sustained period of de-leveraging (i.e. debt reduction) which will be made worse if foreign investors lose interest in lending money to the US. Addressing each of these in turn:

Our assessment is that inflation is the least worrying risk. Inflation in developed countries (excluding energy and food) is running well below the levels preceding previous major global downturns. This suggests central banks have more flexibility this time. Despite the huge surge in oil prices we are no where near 1970s inflation rates.

Insert Table 3

Source: Thomson Financial, AMP Capital Investors

Secondly, inflation always lags the economic cycle. Therefore, with global growth set to slow well below trend this year, it is likely that excess capacity and strong global competition will result in falling underlying inflation over the next year or two. If businesses couldn’t raise prices over the last few years of strong conditions how are they going to push up prices as demand weakens? Already in the US there are numerous signs that underlying inflation pressures are receding, e.g., $1 cups of coffee at Starbucks, falling new car prices, fee cuts on eBay, etc.

Thirdly, barring a Middle East conflict, oil prices appear to be softening for now on the back of slower global growth.

Finally, just because the Fed is easing doesn’t mean inflation is about to take off. That certainly has not been the case after past easing cycles. The problem would only arise if the Fed left interest rates too low for too long, once growth starts to perk up.

Is the debt super cycle over? Probably not. The whole of the post-war period has been characterised by steadily rising debt levels, which some call the debt super cycle.

Source: US Federal Reserve, AMP Capital Investors

Each time there is a financial crisis, fears arise that the prior increase in leverage will result in economic collapse and that cutting interest rates and other methods of reflation won’t work. But it has always worked. There is no reason to assume that it won’t work this time around. In the US, there is plenty of scope for the authorities to ensure it doesn’t turn into a major downturn:

• Interest rates are still well above zero. Even if rates do fall to zero, the Fed indicated a few years ago that more can still be done, e.g., buying corporate debt.
• There is still potential downside in the US$, which will help cushion US economic growth.

While leverage associated with sub-prime problems will need to be unwound, it is worth noting that most American households are not having trouble servicing their loans. The fall in fi xed mortgage rates in the US is leading to a pickup in mortgage refi nancing which can help stimulate consumer spending. So while private sector debt levels in the US are likely to fall, a drastic de-leveraging is unlikely. The biggest threat would be if foreign investors stopped funding US borrowing and triggered a US$ collapse. But the danger of this is low. The countries supplying capital to the US know such a move
would destroy their exporters and are resistant to a sharp fall in the US$ because it means a sharp rise in their own currencies. Currently, there seems to be no reluctance to invest in the US.

What to watch?

While we are reasonably confident that things will turn out all right and that by later this year the trend in share markets will be back up, it’s reasonable to ask what we would look for to tell us that things might be going wrong. So here is a list of what to watch for:

On the infl ation front, a continuing rise in US underlying infl ation and oil prices and a collapse in the US$ would signal problems. Additionally, on the debt super-cycle implosion front; a continued plunge in bank share prices; a fall in US house prices much beyond 15%; a withdrawal of foreign capital from the US; and a collapse in the US$ would also signal problems.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital Investors