Worst may be over but more pain is still to come

Published on Sunday 11 May 2008 21:35

SCRUTINEER

OVER the past month, investors have had to contend with a series of utterly conflicting pointers on the outlook for the stock market and the wider economy.

Central bankers and leading commentators have remarked that the worst of the financial crisis is over. Interest rates have been cut. Stock markets have rallied, with impressive gains in New York and London. The FTSE 100 has rebounded some 14 per cent from its early March lows and is now just 361 points, or 5.8 per cent, down on its level 12 months ago, even after allowing for the sharp fall last Friday.

So has confidence returned? And can investors expect further progress from here as the effects of lower interest rates work through the economy?

Just as stock markets experience corrections on the way up, so, on the way down it is widely thought that brief upward corrections are followed by a fresh downwave that tests and exceeds previous lows.

Some followers of chart analysis predict that the FTSE 100 will breach the previous lows of early March, with the FTSE 100 falling from its current level of 6,204.7 to 4,800 or lower.

However, given that the market is a constantly discounting mechanism, why need it await the formality of a chart pattern to do what is historically expected? And it is by no means a certainty that short-term uptrends in a bear market (assuming, that is, we are in one) are automatically followed by a plunge to new lows.

Back in 1975, after the UK market had fallen some 72 per cent from its peak, it jumped 165 per cent until July 1975, then fell by 35 per cent before doubling again in 1976. There was a short, sharp bout of profit-taking, but no plunge to match or exceed the previous lows of January that year. Bear market corrections are not always the mirror image of bull market ones.

Can investors take comfort from this? Not much, for there have been other signals, none of them reassuring.

We may be past the worst of the first phase of the credit crisis in financial markets. But there are serious "second wave" effects still to work through across the broader economy and company sales and earnings.

Corporate cutbacks, redundancies and closures are on the rise. And the restructuring within the banking sector is far from over. Last Friday Citigroup unveiled plans for a dramatic $500 billion slimdown over the next three years, equivalent to some 20 per cent of current operations.

So there are potent and nasty "second wave" effects still to strike home. The hope is that there will be a sufficient breathing space between the initial crisis and this second wave to enable central bank rate cutting to lift confidence and for the corporate sector to keep retrenchment to a minimum.

That is the hope. What of the reality? The housing sector is under severe pressure. Mortgage lending has slumped by almost half and the drop in house prices over the last six months (8 per cent at an annualised rate) matches the worst of the early 1990s. Readings for net reservations of new homes are at their lowest since 1992.

What of the corporate sector generally? The growth of bank deposits held by non-financial companies (a proxy for cash flow) has slowed sharply. This trend of deteriorating liquidity, Citigroup economist Michael Saunders warns, is a classic precursor to corporate cutbacks. Employment figures are a lag indicator and among the last to show the impact of economic slowdown.

Last week's service sector output figures showed the slowest growth readings in six years. The consensus, he fears, may be understating the severity of the inflationary and recessionary shocks hitting the UK, and that inflation and economic weakness may be much more prolonged than most have allowed for.

Meanwhile, the oil price has continued to surge, climbing to $126 a barrel last Friday with frightening ease. The price has risen 11 per cent since the start of May, hit fresh highs every day last week, and is now more than double the level prevailing at the start of last year.

As if this was not daunting enough for investors, Arjun Murti, the Goldman Sachs analyst who predicted three years ago that the price could top $100 a barrel, has said the "super spike" could take the price to $150 and even $200. Oil at $150 a barrel would push petrol up to some 1.25 a litre and diesel to 1.40, well over 6 a gallon.

There is barely a household, let alone a business, that is not directly affected by the oil price surge and the knock-on effects it has on a myriad of other prices across the economy. And the more we need to pay for energy, the less is available for other household and business spending.

Prices of other commodities have also continued to climb, adding to the global food price spiral. Faced with these inflationary pressures, the Bank of England is hardly in a position to deliver speedy interest rate cuts to cushion the slowdown in the economy and fuel a rebound.

This is not an environment conducive to equities making much headway in the months ahead as companies report weak or falling earnings.

The one consolation is that in some sectors such as banks, housebuilding and retail, the percentage falls in shares have been far greater than the FTSE 100 would suggest. The worst may indeed be over, though more pain awaits.

But for other sectors there is an ominous sense of a rug about to be pulled.