LONDON, 31 December 2007 — The year 2007 was undoubtedly an “Annus Horribilis” for the world economy and the global investment community largely as a result of the downturn in the US economy and the impact of the credit crunch on the global banking system due to investments collateralized debt backed by dodgy subprime US mortgage loans.
As the year stumbles to a close, the world’s biggest banks such as Citigroup, Goldman Sachs, Morgan Stanley, JP Morgan Chase, HSBC were desperately ditching loans with a 10 percent discount — with the so-called leveraged debt market, the money borrowed especially by private equity companies to finance their takeovers, taking the biggest hit. This market is effectively frozen and impacts such activity whether in the West, East or the Gulf Cooperation Council (GCC) countries. The recent $1 billion Dana Gas Sukuk issuance in the UAE and several GCC IPOs, for instance, had to be delayed because the pricing was tight due to the impact of the credit crunch.
Several banking majors have reported huge exposures to the subprime debacle, and HSBC and Citigroup are reportedly looking at offloading assets worth billions of dollars to weather the crisis. In the real estate sector especially in the US and the European Union, property prices are set for a downturn.
Governments, business, banking and investors are indeed bracing themselves for a stormy 2008. With the oil prices at record levels — touching $100 per barrel in recent weeks — some of the oil-producing countries especially in the GCC and members of OPEC will to a certain extent mitigate the impact of the vagaries of the global economy and the international financial markets.
But in a world where the economy and financial system is increasingly globalized, the insulation that surplus oil revenues is supposed to give, soon dissipates. Take for instance the rise of sovereign wealth funds (SWFs) from the Gulf Cooperation Council (GCC) countries, China and Singapore, which are largely invested in the global financial institutions and corporates.
According to estimates by Morgan Stanley, the total assets of nine SWFs owned by the UAE, Singapore, Saudi Arabia, Kuwait, China, Libya, Algeria and Qatar amount to a staggering $2.19681 trillion, of which $1,465 trillion is owned by the SWFs in four GCC countries. The total assets of these SWFs are projected to rise to $12 trillion by 2015. These figures of course do not include quasi-sovereign funds and private liquidity which could easily add another two trillion dollars to the total value of assets controlled by the above countries. With this sort of exposure, the returns of SWFs will undoubtedly too be affected.
Similarly, a crisis in the banking world affects not only access to capital and credit flows; but also the terms of loans especially margins, pricing and yields. Most importantly, it affects market confidence, and investors know that a lack of confidence is the mother of all anathemas in the investment psyche.
According to US investment bank JP Morgan Asset Management, six projected factors will ensure that 2008 will be a tough year for the world economy and global investments market. JP Morgan projects a hard landing for the US economy, although inflation won’t prove a major issue. It expects the Fed to ease monetary policy aggressively and predicts that 2008 will be a turning point for the dollar. The good news for the UK is that is projected to be “the most attractive fixed income market”. The overall impact for the global economy and investors will be “deteriorating risk adjusted returns”.
In the US, the economy, according to the latest data, is on course to soften in the last quarter of 2007. But with quarter-on-quarter annualized GDP growth estimated at below 1 percent, there are increasing fears of a weakening outlook for the US in 2008. The housing market too shows no signs of stabilizing with various home price measures still weakening and demand continues to fall.
On inflation, JP Morgan is much more bullish stressing that inflation should remain relatively well behaved, because real wage growth in the US like in Europe and Japan, is falling. Given that labor forms the vast bulk of most corporate cost bases, this should offset upward pressure from energy costs.
The global credit crunch environment similarly rends to be deflationary, although warns JP Morgan, the policy responses to credit cycle downturns tend to ultimately prove to be inflationary, though this may take a long time to work through.
The year 2007 was difficult for the dollar, which fell by 8 percent to its lowest level since 1980. Is the world economy moving away from the dollar benchmark? On the contrary, financial institutions suggest that the US dollar will bottom out in 2008 because extreme currency valuations in real trade-weighted terms will disappear and the rebalancing of global economies is underway with drastic implications for some of the current account imbalances that have loomed over currency markets.
Asset managers stress that the UK is one of the best performing fixed income markets, ironically because the UK economy faces a serious slowdown due to a long-awaited correction in the highly overvalued housing market and a slump in mortgage equity release, which has hitherto with cheap credit fuelled consumption. This will lead to a household sector cash flow deficit, with a much lower disposable income. UK household debt levels are at an all-time high of 160 percent of disposable income.
Most asset managers in the UK warn that 2008 promises to be a tougher year for investors. Equities will experience higher levels of volatility in the fixed income and currency markets. Uncertainty regarding growth and inflation targets will increase, and this will feed through into more volatile asset markets. This, warned institutions such as JP Morgan Asset management, means that risk-adjusted returns (returns over short-term interest rates adjusted for volatility) are set to worsen in 200, perhaps through to 2009.
