The key barometer for global growth is the US housing market. This market is the biggest store of wealth in the world and the bad news for investors in risky assets is that US house prices are collapsing.
The S&P/Case-Shiller Composite-10 index shows that US house prices fell by 8.4 per cent in the year to the end of November 2007. Annualising the quarterly number reveals a fall of 16.6 per cent, so the downturn is clearly accelerating.
It is certain that the housing crisis will have material global consequences. I believe that the US is already in recession and will remain so until at least the third quarter of this year. The big question is whether we can avoid a 1930s-style global depression.
The crucial difference between the current situation and the one that sparked the Great Depression is that we are not experiencing deflation at the moment. Deflation is the worst thing that can happen to a weak economy laden with heavily indebted consumers and companies because deflation makes the value of these debts increase over time.
The Federal Reserve is slashing interest rates aggressively, which shows that it is absolutely committed to preventing deflation. US government bonds have performed exceptionally well but the problem now is that the US bond market is already pricing in US interest rates falling to about 2 per cent and there does not appearto be much upside. I thinkthe Fed will bring interest rates down to 1 per cent by mid-2008. Rates could even fall to zero and that maystill not be enough.
The Bank of England has so far been slow to react to the very real threat of recession. I believe it must follow the Fed’s lead and slash interest rates quickly.
The UK economy is looking increasingly vulnerable. Lead indicators suggest that the housing market is likely to fall this year, which means consumer spending will inevitably weaken and a UK recession looks more and more probable.
The effects of interest rate cuts take 18 months to work their way through into the real economy, so, despite the recent cuts, we are still seeing credit card and mortgage rates going up.
Admittedly, a weakening economy is already priced in – gilts rallied by 8 per cent or more in the second half of 2007, their best half-year since the turmoil of 1998 – but the UK bond market still only expects interest rates to bottom out at 4.25 per cent.
This is where interest rates were as recently as 2004 and the economy now is weaker than it was four years ago.
Against the weakening economic backdrop, I am very bullish about bonds at the moment, especially gilts and high-quality investment-grade corporate bonds. Many investors are concerned about the prospect of inflation but UK inflation is under control and a weakening economy should result in spare capacity being created which will serve to reduce inflationary pressure.
I am more cautious on higher-risk, higher-yielding bonds. High-yield bonds have performed poorly in the past six months but the market does not appear to be pricing in the risk that the economy could fall into recession.
The big supporting factor for high-yield bonds recently has been the very low default rate. Data from rating agency Moody’s showed that in November, the global default rate reached its lowest level since 1981. It has since picked up slightly but the default rate cannot continue at current levels. The combination of falling company profits and the reluctance of investors and banks to continue lending to higher-risk companies means the default rate will rise and high-yield bonds continue to look fairly unattractive.
Jim Leaviss is head of retail fixed income at M&G