Financial markets have had a volatile few months, and it is hard to see anything changing the outlook in the short term. The global economy will continue to slow as central banks maintain a hawkish posture, oil prices remain high and the wealth effect from rising stock prices unwinds.
If anything, the case for a slowdown has become more compelling over the past month or so as market conditions have tightened, driving investors from risky assets.
Three key factors are causing global economic activity to decelerate.
First, most central banks have maintained their tightening bias and some are still raising interest rates, with the ECB lifting rates again earlier this month.
The US Federal Reserve Board also kept its tightening bias and the implication is that central banks will probably not act quickly to stimulate demand unless financial turmoil threatens the banking system or stock markets fall sharply.
Second, financial conditions have tightened. European and American stock prices have fallen about 3 per cent in the past month and 10 per cent from their peak in March. Of particular note is that many of the frothiest sectors of the financial markets have suffered severe damage.
In the US, the junk bond market has virtually shut down, as yield spreads have soared. In addition, some highly speculative equity sectors, such as Internet stocks, have been melting down.
This tightening of financial conditions has been mirrored outside the US. In the euro zone, swap spreads have soared and are at the same level as during the 1998 Russian T-bill default.
In addition, the technology-laden Nasdaq and the euro-zone telecommunications sectors have fallen sharply recently.
Third, oil prices will more than likely remain high, at least through the winter, and this will sustain the downturn in consumer spending and corporate profit growth. Oil and gas inventories remain critically low and spare production capacity on a global basis is at its lowest level in decades.
The release of US strategic reserves has moderated crude oil prices but they are creeping up again, with tensions in the Middle East not helping matters. Furthermore, the price of natural gas has risen to a new cyclical high.
The bottom line is that the forces that have been acting to slow the world economy are intact. The recent tightening of financial conditions implies that they may even be intensifying. The important issue is whether the world economy is headed for a soft or hard landing.
In my view, a soft landing is still the most likely outcome for the simple reason that "core" inflation remains at a low level in most of the big economies, a situation that gives central banks considerable freedom to cut interest rates if needed.
This general economic environment will remain unfavourable for equities over the next few months. Profit growth is slowing but interest rate relief will not be imminent unless stock markets lurch downwards.
That said, I don't expect a prolonged bear market because central banks have freedom to ease, and hence, bond yields have room to move down. A decisive improvement in valuation would require some combination of lower stock price and/or a rally in bonds.
Liquidity conditions have continued to deteriorate, implying that risks for equities are tilted to the downside in the near-term. In the past, decisive improvement in liquidity conditions only occurred when central banks were cutting interest rates.
However, there are still some good buying opportunities for stocks and in terms of country markets, I like the look of Britain because it offers high weightings in interest-rate sensitive and defensive sectors. The market is also oversold and undervalued in my opinion.
Investors should maintain a neutral weighting overall in the US stock market in the short term, while, in the euro zone, export-oriented equity sectors should outperform, but the broad market is not yet a buy.
All in all, it is likely that most of the declines in global equity markets will occur in technology and cyclical stocks. Defensive and interest-rate sensitive stocks should continue to outperform and could also do well on an absolute basis.
When the technology bubble was inflating last year and early this year, it crowded out the non-technology sectors. Rising tech stocks fuelled an economic boom that forced interest rates higher and the tech sector sucked money and labour out of the non-tech sector. In the past few months, this process has gone into reverse and the non-tech sectors in many markets have been outperforming.
In summary, intervention to support the euro and a fall in oil prices temporarily restored calm, but the main economic and financial market trends remain intact. The world economy is slowing and bonds will outperform stocks until central banks start to cut interest rates.
The main risk is a repetition of the financial market turbulence of late 1998. In this event, bond yields and equity prices would fall sharply, but a quick response from the Fed (lower US interest rates) would stabilise the stock market. The dollar would then have a brief but significant correction against the euro and the yen.
Alan McQuaid is an economist at Bloxham Stockbrokers
