Market Review 23 August 2011

Bob Monkhouse, the British comedian, once said that his dearest wish was to die like his father, peacefully in his sleep, not screaming and terrified like his passengers.

World markets witnessed another dramatic week for investors, who, if not terrified and screaming, were at least in full flight for safe harbour. Brutal declines in developed market equity prices, particularly on Thursday and Friday, contrasted with further declines in bond yields, and new highs in gold.

The S&P 500 was down 4.7% week to date; the DAX, down 8.6%; the FTSE 100, off 5.3%; the Nikkei down 2.7%; and the Hang Seng down 1.1%. Industrial and IT stocks took the brunt of the price declines. Global equity markets, as represented by the MSCI All Countries World Index in sterling, are now down 14% so far in August. Strange times make for strange bedfellows: those markets down over 20% month to date include Russia, Turkey, Italy, and Greece – but also Germany and Korea. Gold rose 6% over the week, and silver was up nearly 10%.

What is the story that markets are currently telling us? Bond markets in the major developed markets are now at new yield lows. Ten year bonds: US at 2.07%; German at 2.10%; UK at 2.39%; Switzerland at 0.9%; and Japan at 0.99%. Given that these yield declines have come after all of the concerns about European sovereign risk and the US debt downgrade by S&P, it is clear that it is fear of economic decline not credit risk that is driving markets now.

Global equities are priced on a forward PE ratio of 10x and a dividend yield of 2.9%, with Europe and the UK both on 8.5x next year’s forecast profits. Even on historic profits, global equities are on 10.4x. Whether equity markets are now actually pricing in a recession, the dreaded double dip, is a matter of debate amongst economists and equity market strategists, but clearly confidence – in equity markets and in the economic outlook – is evaporating, reinforced by Thursday’s weak Philly Fed survey.

Last Wednesday Morgan Stanley downgraded its forecast for GDP growth in the euro zone for 2012 from 1.2% to 0.5%, and at the weekend Goldman Sachs cut its forecasts for US growth in the second half of the year; to 1% in Q3 and 1.5% in Q4, from 2% in each.

There have been policy responses. After ECB intervention in bond markets Sarkozy and Merkel met again last Tuesday, but are clearly wary of committing themselves to economic solutions which may be difficult to swallow politically. Hence Merkel has dismissed euro zone bonds as a solution, but both leaders promoted the idea of a “Tobin tax” on financial transactions.

The Swiss central bank has intervened to try and drive the Swiss franc down. Instead of resolving investor fears about sovereign risk and financial transmission, these fears appear to be shifting into another form, the fear that the policy responses themselves will dampen both confidence and growth.

The greatest concern must be that this “fear” transmits itself into all sorts of activity dampening behaviour, whether a renewed reluctance by banks to lend, consumers to spend, or companies and individuals to invest, and that equity markets begin a downtrend reinforced by further weak data points.

Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton