The Bank of England estimates that the economy will contract by an annualised rate of 1.9 per cent this quarter. Even this looks pretty optimistic. Mortgage approvals are in freefall, house prices are approaching year-on-year falls of 20 per cent, retail sales are suffering and unemployment is rising at the fastest pace since 1991.
The scale of today’s problem is huge and there is no light at the end of the tunnel yet. At the heart of the crisis is the housing market. A healthy economy needs a healthy housing market. In order for the housing market to turn round, mortgage approvals and transaction volumes need to be restored.
People must be willing to buy houses again, and they must perceive housing to be affordable so prices must fall further and the cost of borrowing must be reduced.
Is there anything to be positive about? Last September, when the financial crisis began in earnest, I believe we came very close to the end of banking – a world where banks did not function and individuals lost all their life savings.
The risk of us losing our life savings has now gone away. The volume of ammunition that central banks and governments have thrown at this problem is astounding: cutting rates effectively down to zero, piling vast amounts of fiscal spending into the economy, and keeping banks afloat.
The Bank of England’s dramatic decision to buy back £75bin worth of its own gilts is being done because conventional monetary policy has reached its limit.
Slashing interest rates is no longer enough by itself to jumpstart the housing market, boost economic growth and stave off the threat of entrenched deflation.
The UK and US central banks and governments are writing the rulebook – they are doing exactly what should be done in a financial crisis. For this reason, I do not think we are going to have another Great Depression but while we are seeing a proportional policy response to the world’s economic problems, which gives us some hope, we will not see decent growth for at least a few years to come.
Government bond investors have already emerged as beneficiaries of the turmoil, with 10-year gilt yields at record lows. Gilt returns, since the credit crunch started, have been over 20 per cent.
Over the next year or two we expect the corporate bond sector to dramatically outperform the government bond sector. This will be the reverse of what we have seen over the past couple of years.
Corporate bond spreads are discounting an Armageddon scenario, with an unprecedented number of defaults.
At the moment, assuming average historical recovery rates, around one-third of the entire corporate bond market would need to default over the next five years for corporate bonds to underperform government bonds. We think it is very unlikely that one in three investment-grade companies will go bankrupt in the next five years.
By lending to big, low-risk companies, investors can receive yields upwards of 6 per cent a year, with the prospect of double-digit yields if they want to take on a bit more risk. This makes corporate bonds very attractive as the income on bank savings collapses.
Jim Leaviss is head of retail fixed income at M&G