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Friday, February 1, 2008
Pretty negative

The consensus view for 2008 is pretty negative, with many saying that America will enter recession in the next few months, if indeed it has not done so already. This pessimism was reflected in the American Association of Individual Investors survey, which in late November showed the percentage of equity bulls to have fallen to almost the lowest level registered in the last decade or so.

Comments Peter Lucas of Ashburton, “Although the illiquid state of the money markets is a major cause for concern, we believe that it is quite possible to make a case for making a contrarian stand.”
First, there is the attractive level of equity valuations, at least relative to government bond yields. In America, the gap between 10-year Treasury bond yields and the earnings yield on the S&P 500 and 10-year Treasury bonds has dropped to its lowest level since the end of the high inflation years in the early 80s. This means that even if profits were to come under pressure, the equity market would have a firm underpinning from valuations (particularly given that bond yields would fall further in a recession-type outcome).
“If, on the other hand, the economy was to exceed expectations, there is plenty of scope for equity markets to recover,” he says.
Second, one should not underestimate the ability of the world’s Central Banks to take decisive action at times like this. There are those who believe that any such attempts are doomed to fail, pointing to Japan’s experience in the ‘90s. It is far from clear if history is set to repeat itself. In the ‘90s, the Bank of Japan was rather slow in responding to the economic downturn – the Federal Reserve is unlikely to make the same mistake. Indeed, if Ben Bernanke were to ‘drop money from helicopters’, bonds would likely be in more immediate trouble than equities.
Third, even if the credit crunch does cause growth to slow sharply and even if the Fed and the other Central banks are unsuccessful in their efforts to revitalise the banking system, the Western world still has one other potential saviour.
The West is an important export market for both Asia and the Middle East – it is not in the interests of either to see Western economies drop off a cliff. But what can they do? Thanks to their large current account surpluses, both regions have huge currency reserves that could be reallocated away from bonds into equities. The Western banking system appears to be in need of cash and the East (via its Sovereign Wealth Funds) is in a position to provide it. In fact it’s already started to happen; witness the recent stakes bought in Citigroup and UBS. At these share prices, they look to be getting a pretty good deal.
And there’s more that they can do. As a result of their managed currency regimes, Asia and (most particularly) the Middle East are grappling with a developing inflation problem. Currency revaluations would help them in this battle and would simultaneously throw the West an economic life-line. Will these regions ‘ride to the rescue’ in this way? It is hard to say, comments Mr Lucas. But when there is such a clear meeting of economic interests, it would perhaps be unwise to bet against it.
The world is clearly facing a crisis of some magnitude. However, equity valuations look good, bearish sentiment is off the scale and the economic outlook may not be as disastrous as many currently think. “To us, this is case enough for taking a contrarian position. So our New Year message is quite simple: expect plenty more volatility in 2008 and expect equities to outperform bonds.”

Copyright © Insurance Times and Investments® Vol:21.1 1st February, 2008
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