Panic eases, but ride will be bumpy

May 14 2008 by Iain Laing, The Journal

FOLLOWING a period of relative calm in markets and stronger performance from corporate credits and equities, last week saw the return of some volatility and fear.

The driver seems to have been further inflation fears on the back of rising oil prices and, more important, a flip-over in the assessment of the market risk of further write-downs at financial institutions.

The latest announcements, not least heavy losses at AIG, along with news of strengthened regulatory oversight of US banks, seems to have tipped the balance in the sense that the market is again reacting to negative news flow.

But this seems to be happening in a much more controlled manner than earlier this year; bad news resulting in falling prices of riskier assets, not panic. Based on this assessment, we do not see much reason to change our view that market conditions should improve and equities should perform in coming months, but the road ahead will be bumpy.

Across the Atlantic, we still see the US economy improving, but with pockets of weakness. In the housing market, some of the right political steps have been taken, but more work is needed. The same goes for financial write-downs. A lot has been done, but more is likely to be needed. More positively, it is worth highlighting that the labour market, while deteriorating, is not showing signs of a collapse, while the corporate sector seems to be moving towards stronger profitability. Recent figures show that US domestic profits (as a share of GDP) have corrected substantially.

The recent data on unit labour costs show the same progress. Indeed, US unit labour costs are now well below their long-term average and almost flat year on year. With labour still the largest input cost for US firms, this should soon start to help corporate profitability.

Closer to home, there has been a further deterioration in the UK economy, as evidenced by the decline in the service sector purchasing managers’ index. Also, we have difficulty in remembering much in the way of positive news from housing. The recent Royal Institution of Chartered Surveyors survey for April showed 95.1% more surveyors reporting a fall than a rise in house prices, an increase from 79.4% in March. The message from some regions leaves no room for doubt, with surveyors in East Anglia, the North and North West unanimous that prices are falling.

While the housing market worries us, there is not much the authorities can do to fix what is essentially a valuation problem, and no dramatic help seems likely from the Bank of England. The Bank voted to keep interest rates on hold this month, after last month’s 0.25% cut, which was in line with market expectations.

We will have to wait until the minutes of the meeting are released to gain a greater insight into the Bank’s decision, but it seems the upside risks to inflation in the near term were at the forefront of the Monetary Policy Committee’s thoughts.

So, while the road ahead will not be smooth, our assessment of markets continues to favour equities over bonds and cash over 12 months.

But the trend of “discontinuous improvement” in equity markets looks set to remain for some time.

Andrew Miller is regional head of Barclays Wealth