It has finally happened: The world’s stock markets are now in the thrall of an out-and-out sell-off, with indices hitting new lows on a daily basis. The contagious pessimism and the general feeling of uncertainty appear to be gaining the upper hand. So what is to be done?
Especially in such a volatile and emotional environment, the important thing is to remain cool and adopt an analytical approach.
The economic data published last month on industrial production and capacity utilization confirm the nascent upswing in the US, and the positive outlook for the real economy in Europe also remains intact. In addition to this, there are no threats looming on the inflationary front.
However, there are some dark clouds forming on the consumer side, where negative sentiment and fears of unemployment and a pronounced economic slowdown are leaving their mark. Although Fed Chairman Greenspan has been upbeat and appears not to be concerned, the initial US confidence figures for July have been weaker, dropping to 86.5 from 92.4 in June. The pessimistic picture has also been confirmed in Europe by the confidence figures from Italy (115.2 vs. 118.8 in June). These figures are affected by certain factors specific to the countries in question — e.g. the crisis surrounding automobile group Fiat — but they are nonetheless important in the general context given that they offer the first indication from Europe for July. We therefore cannot rule out the possibility of similar developments
elsewhere in the region.
The crunch question now is whether the prevailing loss of confidence will affect the fledgling upturn in the real economy. To find an answer to this crucial question, we have analyzed the impact certain factors have had on private consumption in the US in the past.
Looking at the period from 1985 and 2002, we find that disposable income has been the key component in determining the development of private consumption.
Over the same period, the wealth effect proved to be of secondary importance, although the latter does make a major explanatory contribution with regard to the change in savings rate. As result there is a negative correlation between the two. For example, the significant rise in assets during the 1990s led to a lower household savings rate.
The comforting realization that private consumption is driven more by disposable income and less by net assets held by private households, prompts us not to overestimate the impact of the drop in consumer confidence on the real economy. The Bush administration’s tax cut programs should continue to support the positive trend in disposable income and the low interest-rate environment is likely to favor investments. In this regard it is worth reiterating that it is corporate earnings and demand that hold the key to capital spending, and not the stock markets. The losses on the stock markets are adding to investors’ jitters at the moment. Nevertheless, we are confident that as soon as investors take the above factors on board, confidence is likely to gradually return and put an end to the negative downward spiral, thus helping the financial markets on the road to recovery.
The prevailing sell-off mood on the stock markets has been good news for bondholders. The yield curve has flattened markedly in the USD market and also the EUR and CHF markets, with the price gains coming mostly at the long end. The Salomon World Government Bond Index has posted a gain of some 12 percent in USD terms in the year to date, with the 5 to 10 year maturities segment notching up the biggest gains (performance + 14 percent). However, not all bond investors have been able to share in this fortune, as corporate bondholders have had a increasingly fraught time. There has been a sharp rise in the yield spread vs. government bonds in all sectors without exception, especially in recent months. The telecommunications equipment sector has been particularly hard hit, with spreads currently as high as 400 basis points. The banking sector has also been adversely affected, particularly due to provisions for possible loan defaults.
There has indeed been a dramatic rise in the default rate. According to a study of European corporate bonds conducted by the ratings agency Moody’s, defaults this year have thus far totaled 24 billion euros (figures to end-May). Telecoms accounted for half this figure, followed by the transport sector. As we stated in our introduction above, in such a volatile and emotional environment, it is particularly important to remain cool and adopt an analytical approach. The macroeconomic data offer no explanation for the current sell-off on the stock markets. The fundamentals, however, are upbeat and we still have a positive outlook for the economy and earnings. We are therefore sticking to our decision to favor equities over bonds. The risk premium (i.e. the relationship between stock returns and the yield on 10-year bonds) has been on the rise. This high level indicates that stocks are cheaper than bonds, which in turn increases the likelihood of a turnaround on the stock markets.
This statement is further supported by the put-call ratio, where the pessimists outnumber the optimists to an unusually high extent. In our opinion, the chances of a recovery on the stock markets are greater than those of a further major correction.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management)