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With the recent market upturn looking like a false dawn, Russ Mould heeds the signs and readies for the storm

quick glance at the world’s trading screens suggests the credit crunch which rocked debt markets last summer and pounded equity markets throughout autumn and winter is becoming no more than a fading memory. Even after the recent sell-off, the FTSE 100 still stands 12% above its March low of 5414.8. America’s Dow Jones Industrials has rallied by 6% since its 2008 trough of 11740.2, also reached in mid March. (see tables 1 and 2).

Emerging markets have also regained their poise as risk appetite recovers. This month’s decision by the major ratings agencies to accord the country’s debt sovereign status has prompted Brazil’s BOVESPA index to smash through the 70,000 barrier for the first time. China’s Shanghai Composite index jumped 15% in just one day last month, after the government cut stamp duty on share transactions from 0.3% to 0.1%, reversing an increase put through 12 months ago.

Even banks, the sector where sub-prime debt losses and writedowns were the first manifestation of the credit crisis, seem to be emerging from the gloom. Investors have happily handed over in excess of $125 billion to banks such as Citigroup, UBS and Merrill Lynch via rights issues and convertible debt offerings, helping to shore up their balance sheets and restore confidence in the debt markets.

Still, many believe macroeconomic clouds are still gathering. Bank of England governor Mervyn King last week warned yet again he believes a decade of low inflation and steady growth is coming to an end. European Central Bank president Jean-Claude Trichet warned, in a radio interview with the BBC’s Robert Peston just last week, inflation remains a key threat and failure to combat it effectively now could lead to mass unemployment in the future. US Federal Reserve governor Ben Bernanke admitted to the Joint Economic Committee of Congress back in April a US recession remains ‘possible’.

Warning signs

None of this seems to tally with the rally in equities seen since March, but just behind the blue screens lie potential warning signs.

UK market breadth remains poor. Just 11 of the 47 sub-sectors which comprise the FTSE indices have generated a positive return in 2008 (see table 3). Almost all of the upside has come from the commodity and resource exposed sectors, a fact confirmed by a table outlining the FTSE 100’s best performers over the last month (see table 4).

Such a narrow band of strong performers does not bode well for the overall health of the market, particularly since strong performers such Kazakhmys and Eurasian Natural Resources can hardly be described as good barometers of UK economic activity.

By contrast, 12 sectors have recorded double digit losses this year. These include banks, consumer services, general retailers and tech hardware, all areas where demand is exposed to any broad economic deterioration.

Claims of a commodities super cycle have swept such worries under the carpet. But similar siren songs of ‘it is all different this time’ were used to justify the Japanese property and banking bubble of 1987 to 1989, the tech bubble of 1998 to 2000 and the emerging market bubble of 2006/07, and none of these arguments stood the test of time. Japan has never regained the peak of 38,915 it achieved on 31 December 1989, the NASDAQ still lies at barely half its March 2000 peak of 5,049 and China’s Shanghai Composite index, even after its recent rally, stands 40% below last autumn’s 6,092 high.

A key test of the current run will be whether the metals and oils stocks in particular can maintain their momentum; as history shows a bull market usually begins when one sector’s leadership is replaced by another. In 2003, utilities, engineers and miners came to the fore, taking over from the then discredited technology, media and telecoms sectors. ‘Before we see the end of the bull market, we have to see sector rotation,’ confirms Ian Harnett of independent research firm Absolute Strategy Research.

Is recession the big risk ?

Such a contrarian view should not be dismissed out of hand. Harnett and business partner David Bowers began the year predicting a 15% drop in European equities, a view which looked prescient after spring’s sharp falls. The duo form part of a select band who are standing against the current rising tide.

These sceptics identify three possible challenges to the bullish scenario of a shallow downturn and rapid recovery which markets have begun to price in: recession, inflation or – perhaps worst of all – stagflation. The news wires this year have certainly been full of negative readings from most of the world’s leading economies.

Research from brokerage firm Dresdner Kleinwort pointed out last week nearly all recent data points from the UK have undershot expectations, including industrial production, consumer confidence, retail sales and housing prices. Data from the Halifax showed a three-month moving average of UK house prices falling by 0.9% in April, the first drop in 12 years. Bank of England statistics showed new house purchases in March fell to their lowest level since 1992, the time of the last UK recession. First quarter UK GDP growth of 0.4% was the slowest advance in three years.

Such macroeconomic gloom is already filtering through to British corporates, if business rescue and recovery expert Begbies Traynor’s ‘Red Flag Statistics for April’ are any guide. Chairman Ric Traynor revealed 3,309 UK firms faced what Begbies terms ‘critical’ problems in the first quarter of this year, a fourfold increase on the number of companies receiving serious actions and judgements compared to a year ago. Another 140,000 ran into ‘significant’ financial problems, an increase of 20,000 on the first quarter of 2007.

But it is not just the UK which is feeling the squeeze. Spanish new housing starts have plunged by 50% from their peaks. Consumer confidence in Spain has hit its lowest level since 2004, and April retail sales in the country fell nearly 9%. French consumer confidence hit a 21-year low in April. March saw Italian retail sales fall at the fastest rate since 2003. Germany’s IFO business climate index read 102.4 in April, its lowest level since January 2006. Belgium’s Courbe Synthetique industrial climate index, which has been statistically proven to lead the euro-zone cycle by two to four months, has just delivered the largest month-on-month drop in its 54 year history.

This gloom has not been confined to Europe. The Bank of Japan, faced with March export growth of 2.3%, a three-year low, cut its domestic GDP growth forecast from 2.1% to 1.5% for the year to March 2009. America, which spawned the first seed of the credit crunch in the form of heavy sub-prime mortgage losses, is starting to feel the pinch, too. May saw the University of Michigan consumer sentiment index slide to a reading of 59.5, the weakest figure seen since June 1980, or four US recessions ago.

US single family housing starts fell 1.7% month on month in April to 692,000, a 17-year low. US housing defaults have reached their highest levels since the 1930s. Although strong sales in Asia propped up their numbers, leading US industrials such as GE and Caterpillar admitted to weak domestic demand, a picture confirmed by exporters into the US, such as the UK’s Aggreko and Sweden’s Atlas Copco.

Inflation...

An economic slowdown would normally ease any bottlenecks in the supply-demand equation and take the heat out of inflation. But in 2008 this has not been the case as agricultural, commodity and oil prices have all rocketed.

Mariann Fischer Boel, European Commissioner for Agricultural and Rural Development, stated the EU saw in February year-on-year increases in the price of bread, cooking oils, eggs and milk of 10%, 12%, 17% and 33% respectively. Wheat and rice prices have soared, with a knock-on effect upon meat prices surely around the corner, as feedstock prices rise. No one needs reminding of how the price of oil has surged to beyond $125 a barrel and taken petrol prices and heating bills up with it. Oil futures have pushed toward $140 a barrel, offering little hope of respite in the short term.

As a result, inflation, known as the cruellest tax of all as it viciously devalues consumers’ earnings, savings and therefore real spending power, has reached 26% in the Ukraine, between 11% to 17% in the Baltic states and 14% in Russia. May Day even saw food demonstrations in Russia, as price freezes imposed in the run up to March’s presidential elections expired, and gas and electricity prices were put up by 25%.

Egypt has also seen demonstrations about food pricing and the government responded with 30% price increases for civil servants. March saw food prices in Hong Kong rise by more than 17%. Singaporean inflation stands at a 26-year high of 6.7%, while April’s Turkish inflation of 9.3% was way above the government’s 4.1% to 6.9% target range. Australia’s CPI soared by 4.2% in April, the highest for 17 years, and the Royal Bank of Australia (RBA) has responded by taking interest rates to a 12-year peak of 7.25%.

The usual response to inflation is higher interest rates, which should also cool off consumer spending and housing activity, as they put the squeeze on mortgage and other debt payments. Higher rates should also force a currency up in value, lessening the competitiveness of exports, further dampening the economy.

Inflation fears mean ECB has refused to cut interest rates from the 4% level, even while the UK and US have been slashing them. But even rate hikes do not always work. Russia has already tried price controls and higher rates but still inflation is soaring, as the country struggles to absorb the billions of dollars which are flooding into it as a result of the booming oil price.

This is not the only structural imbalance visible in the world today, and nor are oil and crops the only source of inflation. In a desperate attempt to stave off recession, the US is flooding the world with liquidity, by cutting interest rates and pumping cash into the banking system, just when the rest of the world least needs it, since it is already awash with petrodollars seeking a home.

‘What we have in the USA is a classic current account deficit response: permitting the dollar to fall and other assets to fall in price, such as housing and equities,’ argues Ian Harnett of Absolute Strategy Research. ‘Through the dollar currency pegs [in Asia and the Middle East] this exports inflation, just as happened in the early 1970s when the US was trying to pay for another war, this time in Vietnam’.

...or stagflation

This parallel with the early 1970s, when the US also allowed the dollar to slide and inflation to ride, in a beggar-thy-neighbour approach to solving its budget and current account deficit problems, is a particularly unpleasant one. The period was characterised by stagflation, as the global economy faltered and inflation ran riot, and also by awful returns for equity investors. An economic and stock market boom in the UK between 1967 and 1972, sparked by 1967’s devaluation of the pound under the Wilson government and summer 1971’s removal of domestic credit restrictions, ended in disaster.

‘Massive flows of speculative cash found their way into supposedly inflation-beating assets as the economy blazed away toward the fastest real GDP growth rate seen in the past 50 years, at 7.1%. Speculators got rich: their nominal equity and house prices really did outpace rapidly rising inflation,’ remembers Nick Stevenson of equity strategy think tank Mirabaud Securities. ‘But the late 1973 oil crisis and subsequent stagflation took the UK equity market’s PE down into single digits, where it stubbornly remained until 1985. Over the period from the 1972 peak to the end of 1982, UK investors lost 56% in real terms.’

Swings and roundabouts

Talk of the UK market plunging to a single digit Price Earnings (PE) ratio for nearly ten years is chilling stuff, and clearly not on anyone’s radar today. But even if the 1970s doomsday scenario is not repeated, that does not mean markets are cheap.

Mirabaud’s Nick Stevenson irons out the effects of cyclical swings in earnings and takes a longer term view by looking at long-run average trend PEs, rather than relying upon a snapshot of just one or two year’s prospective figures.

This number crunching reveals the UK equity market has traded at a long-run average PE of 15.9 since 1985. But that number is bloated by the bubble 1999 to 2002 when the market soared to previously unseen multiples of 20 to 25. Going back to 1965, the FTSE has an average PE of around 12. It could therefore be argued the market is hardly cheap at around 13 to 14 trend, and it might get worse.

‘Either the market is going to show incredible farsightedness and discipline as the waves of a US recession wash on to the UK’s corporate shore or the index is going, at the very least, to retest its March 2003 trough valuation of 10.8 times trend,’ asserts Stevenson.

This implies downside of at least 15% to 20% to the FTSE 100. Nor are the European or US markets cheap, using this metric. Europe trades at 14.5 times trend earnings, compared with an average of 14 since 1986, and 1993’s and 2003’s recessionary lows of around 12. The US looks even more stretched, at 18.2 times average trend earnings, against its post-1946 average of 15.2 and recessionary lows of barely 7 in 1973 and 1982.

The turning of the screw

Of course, arguing the markets should return to levels last seen during the recessions of 1973/74, 1991 to 1993 and 2001 to 2003 assumes a downturn is coming.

Previous painful stock market swoons have all tended periods where excess credit has lead to speculative booms across asset classes; overvaluation and then correction in those assets; and finally tighter, and more expensive credit once losses have been suffered and harsh lessons learned.

The 1929 Wall Street Crash and subsequent global depression, the 1989/90 Savings & Loan crisis in the US, Sweden’s banking and real estate crisis of 1991 to 1993, the Japanese property and banking bust of the 1990s and the TMT bubble of 1999 to 2001 all had excessive speculation using cheap credit at their core. The US housing bust of 2007, with all of its ramifications, looks to be the latest example.

‘The global economy is in transition,’ says Ian Harnett of Absolute Strategy Research. ‘We will have a slower [growing], more risk averse, more tightly regulated world where capital is much more scarce.’

According to numbers from the British Bankers Association, UK mortgage approvals in March fell to the lowest level seen since records began in 1993. The US Federal Reserve’s loan growth survey for the first quarter of 2008 showed 53% of banks surveyed revealed they had tightened lending conditions to large and small businesses, and none had eased them. This compared with 9% who had eased, 88% who had left them unchanged and none who had tightened in the same period a year ago. A third of firms also said they had imposed harsher terms on consumer credit cards, while a year ago 11% had eased terms and the rest left them unchanged.

The knock-on effect of this upon corporates and consumers is not hard to fathom. Since cheap and freely available debt did so much to foster consumer spending and corporate investment, as well as stock market merger and acquisition and share buyback activity, it stands to reason all of these will be hit now that debt is less freely available and only then at a higher cost.

The risk the US consumer is finally forced to pull in their horns, after years of using cheap debt to live beyond their means, represents a major risk to the entire global economy. The first signs of such a retrenchment in Europe may already be emerging.

‘Are families in Spain, Ireland and the UK simply flinching at high-profile reports of declines in property values and choosing to rein in their spending for a while; or are they feeling a genuine squeeze from banks’ loan officers tightening up credit criteria and a rapid deterioration of employment prospects in the construction and financial services sectors?’ asks Mirabaud Securities’ Nick Stevenson, before adding: ‘Whether the explanation is “soft” internal psychology or “hard” economic and financial constraint, the initial result is the same: factory orders for German-produced consumer goods were down 10% year on year in March.’

Some will prosper

This is not to say everything will do badly. The continued strength in mining and oil stocks shows investors can still make money from the markets, even when times are tough. Yet the strength of ‘hard’ commodity prices is hard to square with the risk of a global slowdown and the risk of a major market sector rotation also remains.

‘The collapse of growth – but stubborn persistence of inflation – after September 1973 turned several crack-up boom winners into hefty stagflation losers,’ explains Mirabaud’s Stevenson. He points out general financials, banks and real estate all fell out of fashion – just as they did in 2007 – while oil and gas producers, tobacco and support services stocks did well, before concluding: ‘The entire period is notable for the persistence of structural trends – UK automotive, chemical, engineering, general industrial and media companies were consistently dreadful; UK food & drug retailers, pharmaceuticals, aerospace, electronics and various consumer staples sectors were consistent outperformers over the troubled years from 1967 to 1982.’

The latest equity market rally suggests investors believe the first phase of the credit crunch, namely losses on exotic debt holdings, may be nearing its end. But fresh hits taken by America’s AIG, France’s Credit Agricole and the UK’s Barclays in the past two weeks alone mean this view looks optimistic. Worse, it overlooks the risk of a second, more protracted phase, of deleveraging. More costly debt could be about to begin, transforming the situation from a debt and an equity market problem into a broader economic one.

If so, the recent run may turn out to be no more than the latest bear market rally and a painful trap for those who piled in on the back of it. After all, the Dow Jones Industrials enjoyed six 10%-plus rallies during 1929 to 1932, yet the index still lost 89% of its value from peak to trough. Japan’s Nikkei 225 enjoyed eight such rallies while it careered downwards between 1990 and 2003, and more recently the NASDAQ Composite and the FTSE 100 enjoyed six and four respectively during the 2001 to 2003 bear market.