Why bond markets are right about the economy
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Associate Editor
David Stevenson Dec 04, 2008
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Stocks are still very much in the red
Let's hear it for Ghana.
The Ghanaian stock exchange is the planet's top performer this year – up a cool 60% to be exact. And in sterling terms it's up by two-thirds.
But nearly every other equity market in the world, including our own, is in a complete tailspin. And despite more and more bulls poking their heads above the parapet, the latest news is extra evidence that the selling's set to continue...
It's not time to start buying again, despite what the optimists say
It's December – classic year-end rally territory - yet shares keep sliding. Everywhere, that is, apart from in tiny backwaters like Ghana, where trading still takes place using whiteboards and paper slips, according to Reuters, and where the hedge fund battalions have been mercifully absent.
But here in Britain, despite yesterday's late uptick the FTSE 100 is still down 10% over the last month and 35% since the start of 2008. The fall from last year's peak is almost 40%.
So it's inevitable that some optimists are emerging from the woodwork telling us it's time to put our buying boots back on. Indeed, over the last few weeks an increasing stream of analysts has been suggesting that there's plenty of what they like to call "potential upside" in share prices right now.
Last week, the veteran market analyst Barton Biggs declared: "we're setting up for the mother of all bear market rallies".
Now it's the turn of the Royal Bank of Scotland strategists. They reckon investors should exploit the "extreme opportunity" served up by stock valuations, which they believe are overstating how much corporate earnings will slump. Although company profits in Europe may slip a further 18%, they say, current share prices suggest a 45% profit drop. So they're "expecting equities to rise substantially".
We're all entitled to our opinions. As a former colleague of mine repeated whenever anyone disagreed with him: "it takes two views to make a market". And right now, I reckon we'll be lucky if we 'only' see an 18% fall in European company profits. It feels like we're entering a recession that's going to run and run.
Because yesterday provided some killer blows to the optimists' case.
The outlook for making money next year is terrible
The latest CIPS/Markit take on Britain's service sector, covering everything from hairdressers to hotels, showed business activity plunging even more than expected to a new record low in November. This signals "the worst contraction in the sector since the 1980s", says Capital Economics, implying that GDP growth "will be even weaker next year than the -1.5% we currently expect".
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Further, the 'new business' and 'future expectations' sections have both fallen off such a steep cliff that the outlook for anyone trying to make money in the UK next year is appalling.
Nor was there much cheer in the November Nationwide Consumer Confidence survey, whose main index dropped to its lowest since the report began four years ago. Again 'expectations' looked bad, with nearly 60% of respondents worried that there won't be many jobs around in six months time.
And they're right to worry. The latest Bank of England figures on the amounts of money held by what it quaintly calls 'private non-financial corporations' – businesses that make or sell things, to you and me – are also getting worse. Company cash balances are now down by more than 5% on last year. It all points to UK Plc running out of money even more quickly. As we talked about last month (Companies are leaking cash - that's bad news for jobs), that's bad news for jobs – because it means a real squeeze on company profits.
A depression is next to come
The equity bulls aren't pricing this in - but the bond markets are. Yesterday saw the cost of credit default swaps (CDS) – insurance that investors can buy in the market to protect themselves from default – covering both high-yield and investment grade European corporate bonds soar to their highest level yet recorded.
In other words, CDS prices are saying that companies are going to find servicing their debts enough of a challenge, let alone making much in the way of profits.
"Markets are pricing somewhere between a recession and a depression, and that's what we're faced with," said Philip Gisdakis at UniCredit. "We are already in a recession. The next economic phase will not be recession, but depression." UniCredit is forecasting a 35% chance of a global depression, as job markets deteriorate and consumer confidence is undermined even more.
So there you have it. The upbeat view from equity analysts; versus a really downbeat one from bond watchers. I know which one I believe.
As Morgan Stanley's much-followed strategist Teun Draaisma, who's just changed his mind about turning bullish, puts it: "Throughout the year, we thought that this bear market was like the early 1970s or 1990s, when the market low is reached early on once inflation peaks, valuations are cheap, and policy makers panic. But we're not so sure anymore. Today, given the challenging fundamentals, we prefer cash".
All the evidence adds up to stock markets heading further south. Yes, there could be something of a pre-Christmas rally. But apart from a few individual stocks, unless you are lucky enough to unearth another Ghana, it's still dangerous to buy back into the wider market yet.
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David Stevenson
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