Since the credit crisis started last summer, however, the landscape has dramatically shifted and deteriorating economic conditions have sapped investors’ risk appetites.
July brought a reversal of fortunes, with energy and materials falling significantly while the financial sector, the source of the meltdown, rebounded from its lows as investors started to take advantage of attractive valuations.
Such optimism was short-lived, however, as ongoing concerns about the strength of balance sheets among those companies most exposed to the US housing market led to fresh falls.
Such was the loss of confidence that the US government had to step in to save Fannie Mae and Freddie Mac, together with rescuing AIG, the world’s biggest insurer. These companies were deemed too big to fail.
Lehman Brothers was not too big, however, and in allowing the investment bank to founder, the US government was effectively reminding the market that it recognised the problem of moral hazard and that it would not bail out every problem company.
This was a welcome move because it should speed up consolidation and encourage decisive action to be taken sooner rather than later. Driving weaker companies into the arms of better capitalised rivals, as happened with Merrill Lynch/Bank of America and HBOS/Lloyds TSB, should help to remove some of the worry spots and speed up a return of confidence as well as allowing margins to recover as competition is removed.
Nevertheless, the ultimate second round effects of house repossessions and credit default losses have yet to be fully felt on balance sheets and further writedowns are likely, especially in Europe, where leading economic indicators are deteriorating fast.
But there are emerging signs that the bottom in the US market may be approaching. The first into a crisis is often among the first to recover and the US appears to be faring better than most expected. Moreover, the US government and US Federal Reserve have shown their willingness to take early and decisive action to promote growth in the economy.
In contrast, central banks with specific inflation targets are clearly in an awkward position because meeting those targets in the short term may not mean taking the most appropriate action for the present economic and credit environment. It seems inappropriate to tighten monetary policy in response to higher oil prices when it is apparent that there is negligible feedthrough into wages and global growth remains weak.
That said, the US Federal Reserve can be allowed a greater degree of pragmatism because it does not have a sole mandate of curbing inflation – it also targets full employment.
Further oil price falls are likely this year, a trend that should calm inflationary fears and give central banks more room to manoeuvre, in turn boosting equity prices. Over the long term, however, the factors underpinning the oil price remain intact, with demand from emerging markets strong and lagging growth in global oil production.
Thus far, the global economy has weathered the rise in oil prices and disruption in credit markets remarkably well, albeit that the financial and economic risks have climbed considerably in recent weeks. There could be further slippage in equity prices before a sustained recovery can be achieved, given that no clear catalysts for a rise are evident.
In this environment, investors must strike a careful balance, resisting momentum chasing as well as the urge to stick their heads in the sand. The best strategy is to seek additional sources of diversification, focusing on investments with high earnings visibility and supportive valuations.
Mark Harris is head of New Star funds of funds team