News

Investment Review Quarter 1

Overview
The first quarter was dominated by a turbulent few weeks for the world’s stock markets as investors worried about gyrations in the US sub prime mortgage market and possible knock-on effects for the US and world economies.  In this, our latest investment review, we look at what all the fuss has been about and try to draw a few conclusions for investment in the months ahead.

Equity markets
It has been a roller coaster ride for the world’s equity markets since the start of the year.  As Chart 1 shows, markets began the year well.  By 26th February the MSCI world index (in dollar terms), the FTSE 100 and the Dow Jones Euro Stoxx 50 index were all up by nearly 4%, while the Japanese Nikkei 225 had risen by nearly 6%.  The laggard was the S&P 500 index – but even that had risen more than 2%.

Then came February 27th and a raft of nasty coincidences.  First, the Chinese equity market fell by around 8% in one day amid rumours that the tax regime for capital gains was about to change.  Then, former Chairman of the Federal Reserve, Alan Greenspan – a man whose every word the market still hangs on - used the dreaded ‘R’ word, recession, in an interview with a journalist.  Then, to cap it all, stories began to emerge that a number of US sub prime mortgage lenders were running into serious trouble. 

But what are these sub prime mortgages, and why the market’s concern?  Essentially, they are loans for house purchase made to people who, for one reason or another, would normally struggle to get a mortgage, usually because their income is too low or unreliable,.  In the low-interest-rate, housing boom environment of 2002-2005, a number of new American finance companies sprung up specialising in providing this type of loan to supposedly ‘bad risks’.  Some of the new mortgage products offered so-called ‘teaser rates’ – introductory interest rates that were extremely low (1% or so in many cases), but which reverted to fairly penal rates after a few years.  Other, so-called ‘negative amortization’ loans, allowed borrowers to make monthly repayments that were too small to pay down the mortgage itself (so that the size of the loan increases over time), on the assumption that house price inflation would continue to be so high that borrowers could eventually sell and repay the mortgage that way. 

Other institutions would package up portfolios of these high-risk mortgages and sell them as “securitised” instruments on the international capital markets.  Because these loans offered much higher interest rates than standard mortgages, they looked attractive to international investors in search of yield in a low-return environment.  And of course, this was all fine so long as times were good, house prices were rising and default rates were low, but the danger always was that firms making the loans had miscalculated how many of them might go bad once interest rates started to rise.

And so when it became clear that some of these sub prime mortgage lenders were heading for trouble – notably New Century Financial, one of the largest – the markets took fright.  Although sub prime lending itself is a very small part of the overall mortgage market in the US, the fear was that their problems might spill over into the balance sheets of larger financial institutions triggering some kind of systemic financial crisis.  On top of that, there were fears that the housing market might be driven into a nasty downward spiral, with falling house prices forcing more highly-indebted, income-constrained borrowers into default, and rising repossessions raising the supply of houses for sale, driving prices down further etc.

These fears were at their most intense during the first two weeks of March, but things have calmed down a bit since then.  As Chart 1 shows, by March 13th all the world’s major equity indices had fallen significantly below their start-of-year values.  Interestingly, some European markets fell by more than the S&P 500.  But as the chart also shows, by the end of the quarter the major indices were all back into positive territory for the quarter. 

So why have markets recovered?  And what conclusions should we draw looking forward?  There were many catalysts for the (mild) recovery, but one factor was particularly important.  The key issue was always going to be whether the problems in the sub prime market were going to spill over into other areas, and as time has gone by it looks more likely that those problems can largely be contained.  Also, because the risks associated with sub prime lending have been spread, via the global capital market, over a large number of highly dispersed investors, the risk that a major financial institution would be brought down by this lending appears to have receded.  Finally, the much-feared generalised house price crash has not yet materialised, though nervous investors are keeping close watch on all the housing market indicators.

The more relaxed view the market came to in late March was reinforced by the belief that the Federal Reserve was on top of the issue and would be quick to cut interest rates should things start to get worse for the economy.  And of course it is still the case that American company balance sheets outside the small sub prime lending sector are very strong. 

However, that does not mean we can call time on the sub prime saga just yet.  The US housing market still looks vulnerable and investors will be keeping a close eye on developments there and in consumer spending more widely over the coming months.  Moreover, there are legitimate concerns that the profit cycle looks to be near a peak and that returns look vulnerable to a slowdown in profits growth.  For all these reasons, the US equity market is likely to be nervous for a few months yet and volatility, which has been so unusually low for so long, may well stay high for a while.

Bond markets
So how did global bond markets react to all this stock market turbulence?  The answer is - not surprisingly – almost as its mirror image.  The world’s developed economy government bond markets began this year with yields on a modest rising trend.  However, the equity market turmoil caused bond yields to fall and prices to rise as investors sought sanctuary from the volatility of higher-risk asset markets in good old fixed income.  But as equity markets recovered ten-year government bond yields started to rise once again - as Chart 2 shows. 

By the end of the quarter the yield on a ten-year UK government gilt and German government bund were respectively just over 0.2% and 0.1% higher than where they had started the year.  By contrast, both the ten-year US Treasury yield and the ten-year Japanese Government Bond (JGB) yield both ended the quarter marginally lower than at which they began.  Perhaps not surprisingly, the best performing bond market in the first quarter was also the world’s highest quality - the US Treasury market - where ten-year Treasuries generated a total return of 1.5%. But JGBs and Bunds also produced positive total returns of 0.76% and 0.13% respectively.  The rise in yields for ten-year gilts over this period meant that total returns were negative for the quarter at around -0.50%.

Economic growth
Elsewhere, the latest news about economic activity – most of which pertains to the fourth quarter of last year – has been pretty good.  By and large the world economy continues to grow strongly, though there are tentative signs of a mild slowdown appearing in some key countries.

The US economy expanded at an annualised rate of 2.5% in the fourth quarter of 2006. That is somewhat slower than in recent quarters, but not as weak as some commentators feared. The downturn in the housing market – and in particular the fall in new housing starts – explains much of the recorded slowdown.  But the good news was that despite this slowdown, consumer spending remained pretty robust.  Taking 2006 as a whole, US consumers contributed 2.5% to growth in 2006, a little higher than the contribution in 2005.

Meanwhile, the euro area economy is doing very well.  In 2006 it grew at an above-trend rate of 3.3%, the strongest growth recorded for the region since 2000.  Moreover, that growth was broad-based across a wide range of euro area countries, and not overly reliant on the ‘tigers’ like Spain and Ireland, as it has been in the recent past.  Germany, in particular, looks a lot more competitive than it has been and most of the surveys there suggest growth is soundly based.  In addition, Euro area growth looks to be less reliant on exports than it has been – i.e. less dependent on growth in other economies.  Of course, there are still longer-term structural constraints in the Euro area economy that mean it will struggle to grow very quickly, but there are reasons to be optimistic about the future.

The Japanese economy ended the year on a growth high.  It expanded by a respectable  2.5% last year, but this expansion was fairly volatile.  In Q3 last year the economy stagnated, growing by just 0.1%, only to rebound in Q4 as it expanded by an impressive 1.3%.  The sharp pick up in growth over the final quarter was largely driven by a sudden revival in consumer spending, along with a significant contribution from private fixed investment too.

UK economic growth picked up during 2006: overall the economy expanded by nearly 3% over the full year. But perhaps just as important for the growth picture was its much better balance. Consumer spending grew by less than the economy overall for the first time in several years, while business investment boomed and the contribution from net overseas trade was close to zero. However, there are early signs that the housing market is responding to the higher interest rate environment (see below), and should this mark the beginning of the long-awaited housing market slow down, then economic growth may slow along with house price inflation.

Monetary policy & inflation
The Federal Reserve Open Market Committee (FOMC) kept American interest rates at 5.25% during the first quarter of this year. In his recent monetary policy report to Congress, Fed Chairman, Ben Bernanke restated his view that the current policy stance was consistent with both sustainable economic growth and with a gradual ebbing of core inflation. However, despite the Committee’s concerns about inflation, the money markets still expect a cut in interest rates towards the end of this year.  This expectation largely reflects concerns about the problems in the US housing market, which they believe will spill over into lower economic growth over the course of 2007.

At its December meeting, the European Central Bank (ECB) voted to raise the official interest rate by 0.25% to 3.5%, and then subsequently raised rates in March to 3.75%. ECB officials continue to describe policy as ‘accommodative’, and liquidity as being ‘ample by all plausible measures’. That means they think interest rates will be going up again soon, and the markets are taking the ECB at its (implied) word.  They currently expect rates to rise to 4% later this year as the economy continues to grow strongly, and as part of the return to a ‘normal’ interest rate. It is unusual for the markets to be expecting US and European interest rates to be moving in different directions.  Whether there is a need for rates to rise above 4% is likely to depend upon developments in the labour market. Governing council members consider that ‘stronger than currently expected wage developments pose substantial upside risks to price stability’. And have therefore vowed to monitor upcoming wage negotiations and wage inflation ‘very carefully’.

In Japan, the policy rate was raised to 0.5% in February, with a vote of 8-1 on the monetary policy committee (Deputy Governor Iwata being the lone dissenter). The strong growth data for Q4 of last year (see above) was seen as the main catalyst by analysts for a move that many Japan watchers had been expecting a month earlier. But the economic data are not unambiguously strong. In fact, the growth in consumption over Q4 merely offset a similar-sized fall in Q3.

The Bank of England has now raised interest rates by 0.75% points since last August, the last of these rate hikes being the surprise move in January. The Bank’s latest Inflation Report, published in February, supports the consensus market view that rates will rise one more time in this cycle to 5.5%.

Looking ahead
According to the survey conducted by Consensus Economics of the world’s economists, 2007 is not going to see a recession, though growth overall expected to be a bit lower than in 2006.  Mind you, that comes against the background of the strongest five years for global growth since the Second World War.  As the left hand side of Chart 3 shows, G4 growth is expected to average just over 2%, with the UK expected to be the best of the performers.  But this is much lower than the growth achieved over 2003.  However, outside the G4, in the Asia Pacific, Eastern European and Latin American regions, growth is expected to be much stronger. 

The expectation of lower growth in 2007 in the developed world is reflected in the inflation expectations of the Consensus Economics survey.  The right hand side of Chart 3 shows that inflation is expected to be below 2.0% in the EU and in the USA, and only marginally above this level in the UK, a level that would be very close to the mid point of the MPC’s target range.

This bulletin is intended for professional advisers, market counterparty or intermediate customers and pension scheme trustees only.  The content is provided for information purposes and should not be viewed as investment, legal, regulatory or tax advice.  Any opinions expressed are those of Morley Fund Management Limited.

Unless stated otherwise statistics are sourced from Datastream.

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