July was an extraordinary month for global financial markets. Across the world, stock markets witnessed buying frenzy, experienced escalated levels of euphoria followed by dramatic declines in price levels as fear and panic gripped the markets on US sub-prime mortgage concerns. The Dow Jones hit a record high of 14,000 on July 19; on July 31, it was down to 13,212, a decline of over 5.6 percent. Similarly, the MSCI World Free Index suffered a fall of 5.4 percent from its July 19 high of 405.44.
There is reliable evidence to lend support to the fact that real economic growth is strong and robust. The increasing level of globalization, higher productivity coupled with low costs of production and demand-driven growth across emerging economies has brought about a paradigm shift, perhaps a structural one in the economic fundamentals driving the global engine of growth.
The base case for investing in global equities remains unchanged. Global economic growth is robust in a low inflationary environment characterized by rising productivity and strong corporate balance sheets. The IMF recently increased its global economic outlook. Earlier the IMF was forecasting 4.9 percent growth; it is now looking at 5.2 percent growth for this year and 5.3 percent for 2008, with minimal risk of inflation.
Global equity markets are trading at a P/E of around 15 times on forward earnings. This does not appear rich as the macroeconomic backdrop does not depict a negative scenario for equities as an asset class. Corporate profitability is at extraordinarily high levels and is still rising, although at a slower pace than in recent quarters.
Over the past three years, global GDP growth has been over 5 percent, well above its 30-year average of 3.7 percent. The health of the global economy is reflected in its resilience to a trebling of oil prices while a benign interest rate environment, the steady cost of capital together with ample liquidity has provided support to the world economic system.
However, a change in risk aversion levels coupled with concerns about the potential fallout of increasingly high correlations across international financial markets occurred. The nervousness began in February this year when concerns about the US sub-prime mortgage market first surfaced. At the time, markets became jittery as well but regained traction on the back of strong first quarter corporate earnings, robust economic growth and strong corporate takeover activity.
The contagion is now spreading rapidly and repricing of risk in financial markets is no longer confined to the US marketplace. The US 10-year bond yield has declined from 5.12 percent in mid-July to 4.73 percent currently, reflecting a shift in asset class from equities to fixed income (as money is diverted into a less risky investment option).
The fundamental source of default risk now depressing mortgage-backed securities and related derivatives is the slump in the US housing market. This risk of default is spreading across other markets as well and the associated rise in the cost of capital is fuelling concerns of the adverse consequences for global growth. The potential impact of this malaise on equities is potentially serious. A substantially higher cost of debt capital would impair equity valuations while a sustained rise in the cost of capital could put overall economic growth at risk. It would also bring to a halt the relatively inexpensive financing of takeovers.
The US Federal Reserve, ECB and other central banks are of the view that recent developments in financial markets are a long-overdue rationalization of risky asset prices. To avert a crisis of confidence, the major central banks have injected about $136 billion of liquidity so far into money markets, in an attempt to avoid a credit squeeze. The US markets are now pricing an 80 percent chance of a Fed rate cut (from 5.25 percent) by the end of this year from virtually none prior to the crisis.
The implications of these developments in international financial markets for Saudi Arabia are twofold. First, if the increased volatility continues for a prolonged length of time, and results in a sustained increase in the cost of capital, this could hurt global GDP growth. Such a slowdown in economic growth is likely to result in a softening of oil prices, perhaps by 10-15 percent from current levels as demand weakens. The resulting reduction in crude oil prices will reduce Saudi Arabia’s export revenues. As the share of the oil sector has been averaging around 40 percent of the country’s GDP, unless the drop in oil prices is drastic, such a decline will not derail the government’s economic plans and initiatives. The Kingdom’s economy is likely to experience a GDP growth of over 5 percent for both this year and next.
Second, the recent widening of credit spreads has been sharp, especially in the high yield and emerging market segments. This spread widening is also spreading to other credits and is likely to affect the cost at which Saudi corporates can raise capital internationally. Equity volatility and credit spreads reflect the pricing of risk across a firm’s capital structure and, as long as the return on investment continues to be greater than the cost of borrowing, such transactions will most likely be executed. Apparently, Dana Gas and Ithmaar Bank sukuks have been delayed due to the prevailing weakness.
Until a few months ago, there was continued debate about whether the world could decouple from a slowing US economy. According to Morgan Stanley, an investment bank, the world economy has decoupled. However, from the experience of the past few weeks in the financial markets, it appears that this “decoupling” phenomenon has not yet been widely accepted. It may take some time before the financial markets and economists agree on this. Till then and until there is more clarity on the extent of losses related to the US sub-prime market, heightened volatility may prevail and asset class risk may continue to rise, further pressurizing equity markets.
(The opinions expressed in this article are those of the author himself and do not reflect the views of the organization he represents.)
(Farhan Mahmood is head of Asset Management at FALCOM Financial Services, Riyadh.)
