Few signs of investors capitulating

Jun 4 2008 by Andrew Miller, The Journal

FOR most of the past year, riskier assets have been under pressure, as the US sub-prime crisis and toxic financial over-engineering sent shock waves through markets.

A few weeks ago, the markets appeared rather calmer and there were signs that stability was being restored. But the oil price has spiked again, forcing the issues of inflation and possible growth disruption back to the top of the agenda, along with the question of whether it is still safe to stay overweight in riskier assets such as equities.

Despite increasing constraints on central banks, we do not think it is time to cut exposure to equities. It is perfectly rational for equities and bonds to sell off somewhat as the oil price rises. But there are few signs that investors have capitulated, as was the case in January. We therefore expect the fundamental picture of attractive valuations and an improving growth outlook to support equities relative to bonds going forward.

There is strong anecdotal evidence that some of the larger and more experienced players in the credit space are continuing to move into the credit, high-yield and leveraged loans markets – where they see good value not just in our ‘base case’ scenario (where the US economy picks up in the second half of the year), but also if a US recession lasts longer than expected. In other words, while there are risks to the outlook, enough has been priced into riskier assets to ensure a functioning market. As such, risk can now be traded by those who see opportunities and have risk budgets.

Returning to the fundamental picture, inflation fears have again returned to the market. These, along with improved macroeconomic data, have substantially increased government bond yields. Under normal circumstances, higher government yields should be bad for equities. But, at present, we think a substantial part of the rise in yields is associated with a smaller probability of a ‘doomsday’ scenario and, as such, is partly positive for riskier assets, especially equities.

This is not to suggest that worries about inflation and growth will not affect equities. But it is important to keep the situation in perspective. While prolonged increases in headline inflation and the return of high energy prices make it harder for central banks to loosen monetary policy, parallels with the 1970s are exaggerated; inflation is in no way comparable to the levels seen back then.

Perhaps more importantly, the intensity of energy use in developed and developing economies alike is much lower, while automatic wage indexation (which helped push up inflation during the 1970s) has been dismantled. In the wider US economy, the weaker growth picture should also counter much of the inflationary impact of higher oil prices.

At the aggregate level, economic growth has been below potential for the last few quarters, and is expected to remain so into 2009. From a supply/demand perspective, it is hard to argue that inflationary pressure will not decline in an economy where house prices are falling at the same time as unemployment is rising and nominal wage growth slowing.

Yes, workers are worried by high energy prices, but concern alone does not translate into bargaining power.

While inflation has increased lately, and the average US consumer might expect higher prices to be around for a while, the overall dynamics of the economy should force inflation downwards.