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Alan Kohler's 2008 preview
Despite the fall-out from the sub-prime crisis, Alan Kohler predicts some solid sharemarket returns in 2008 but doubts they’ll be has high as the 20% of recent times.
My prediction for 2008 is that the global economy will muddle through America’s problems with sub-prime mortgage defaults, and that the sharemarket will likely produce another year of double-digit returns – but not 20% again.
There are risks with that scenario, which I’ve set out below, but this view is based on three observations about the reality of what’s going on, as opposed to the rhetoric:
* Not all banks are affected by sub-prime, and those that are have not been fatally wounded (yet).
* The housing collapse has been going for two years and has not sent the US economy into recession – indeed the data is suggesting that the fourth quarter of 2007 may be the low point in the economic cycle (followed by an insipid first half of 2008).
* Whatever happens, China will be largely unaffected, and in fact will benefit from an imported soft landing cooling its economy and inflation rate.
* There is no real evidence at this stage that the losses from the sub-prime crisis will be any greater than those from the savings & loan crisis of the late 1980s – that is, 2.5% of US GDP ($US350 billion or so).
But in the past few weeks, bank-lending spreads have once again widened and banks are hoarding their cash again, fearful of the unknown losses buried within the other banks.
When the crisis first blew up in August, any inter-bank lending for longer than one week was basically frozen and the spread between overnight swap rates and inter-bank offered rates LIBOR (London inter-bank offered rate) and Euribor (Euro inter-bank offered rate) became stratospheric. That gap then shrank for a while, but has now blown out again.
The spread between the one-month Euribor and the overnight rate fell from a peak of 41 basis points to 10bp by mid-November. Now it has increased to a bit less 20bp. It’s much worse for three-month money: the gap reached 95bp in September, fell to 17bp and has now hit a new high of 98bp.
Once again central banks, including Australia’s Reserve Bank, are injecting large amounts of cash into the system to bolster liquidity in the money markets.
Meanwhile, although lending standards have tightened dramatically for residential mortgages (as they should), the tightening of standards for industrial and commercial companies has been relatively modest, according to the latest Fed Loan Officer survey.
In fact, the reaction to the sub-prime crisis in lending to corporations at this stage is nowhere near the degree of tightening that occurred in 2000-01 and led to a recession in the second half of 2001. The cost of funds has gone up, but money is available.
In November, as a result of the sharp increase in inter-bank rates, global equity markets had one of their worst months for nearly five years.
In December, markets bounced back strongly – first on optimism that the Federal Reserve will cut rates on 11 December (overnight Tuesday, Australian time) possibly by 0.5%, and keep cutting next year; and then on some positive data about the US economy that suggests a recession may be dodged.
So at this stage my core “muddle through” forecast is looking pretty good, but there are four major risks to this scenario:
* The losses the banks declare continue to escalate and go beyond what is expected, bringing with it a serious impairment of the willingness and ability to lend. That would cause a general liquidity squeeze, the Fed would have to cut much further and the US dollar would likely collapse.
* The US housing market keeps falling, which would lead to a serious cutback in consumer spending.
* The money markets don’t return to normal in the New Year and undergo a prolonged period of seizure and elevated spreads.
* Oil prices don’t fall. It’s quite clear the oil market is currently being driven by hedge funds rather than demand/supply fundamentals, and this should return to some form of normalcy early in 2008. If, for some reason, this does not occur and oil prices even rise further, the resulting inflation would see the Fed paralysed and any growth rebound next year would be jeopardised.
In fact at this stage oil supply has failed to respond to high prices. One reason for this, according to a paper by an analyst with Royal Bank of Scotland, Thorsten Fischer, is a protracted shortage of drilling equipment and skilled labour, which has caused exploration costs to escalate, delaying many projects.
Investment in reserve development is also hampered because the most promising projects are under the control of national oil companies, which are offering unattractive terms to foreign investors.
OPEC has also restored discipline, largely because Saudi Arabia, the only producer with significant spare capacity, is exercising some restraint. This has removed about one million barrels a day from markets, a third of total estimated global spare capacity.
The other thing is that the fall in the value of the US dollar has contributed to higher oil prices. OPEC has experienced a decline in the purchasing power of its revenues (which are denominated in US dollars) and expects compensation through higher prices.
As 2008 goes on, oil and food prices could push sub-prime mortgages off the business front pages, especially if these two issues combine to produce a bout of stagflation (slowing growth plus higher inflation) in the US.
There are a lot of risks and uncertainties with investing now, and some DIY super fund operators I’ve been speaking to you have responded by switching entirely into cash.
My own portfolio has about 10% cash at present and I am comfortable with that.
But cash levels are a matter of sleeping at night. My friend Peter, reading about the sub-prime crisis, could not sleep easily until he sold all his shares and had his entire portfolio in a term deposit with the bank.
Fair enough. It is not too hard to persuade yourself that by getting 7% or so from the bank you will probably only miss out on a few percentage points of performance next year: the sharemarket is most unlikely to produce 20% total return again next year given the headwinds from the credit squeeze.
The trouble with that are the transaction costs and the taxes … also I’m confident that some stocks will do much better than 10% return next year.
Bottom line: don’t respond to the 10% chance of economic calamity from the US sub-prime meltdown by getting out of the market entirely. It just means you’ll have a 90% chance of a five-year setback to your long-term investment strategy.