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Looming icebergs

This year is undoubtedly going to be a more difficult channel to navigate than we have experienced recently. Economic activity is slowing and even the die-hard optimists acknowledge that the global economy will do well to pull through this phase without dipping into recession. Emergency interest rate cuts by the Federal Reserve and a fiscal stimulus package merely serve to underline concerns for its domestic economy. Evidence of a slowdown in activity in some emerging markets, albeit from high levels, adds further to the gloom pervading world stockmarkets, as does reluctance by the UK and European central banks to intervene and support growth when it is most needed.

At the last count, over 30 stockmarkets had officially entered bear territory – a decline of 20 per cent or more from peak – but prospects for a rapid recovery in the near term look slim.

Two factors define the outlook for stocks and bonds this year. The first is the extent to which worrying issues in the credit markets can be alleviated. Emergency injections of capital from sovereign wealth funds and the Middle East provide a temporary respite to the sub-prime debacle and, it can be argued, put some sort of floor under housing-related issues for the most exposed investment banks for the time being. Yet there are outstanding issues that will continue to affect many banks and financial institutions, whatever the level of interest rates. The monoline insurance problem is the latest in a series of financial issues, following hard on the heels of structured investment vehicles, but is potentially the most toxic and arguably at least as big an issue as sub-prime. We are likely to see an increase in bad debt provisions as a result of increased delinquencies in 2008 while corporate debt defaults which will surely rise significantly from historic low levels.

Corporate earnings are the other moving target that remains hard to gauge. I have seen many comments suggesting that equities are cheap from an historic point of view but until there is greater surety about what the E in the P/E will be, markets will remain on alert.

We could be entering a slightly more stable environment but a relatively cautious stance seems appropriate. More interest rate cuts seem likely and any financial rescue package for the monoline insurers – by no means guaranteed – would help alleviate stress in the financial markets. We continually remind ourselves that even in difficult markets, snap rallies can be quick and meaningful. A highly vigilant and responsive investment strategy will be required while portfolios will may need to shift in orientation quite significantly in response to market direction.

Gary Potter is co-head of multi-manager at Thames River Capital


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