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Recession or no recession?

Economic outlook Kevin Telfer, fixed-income product specialist at Aegon Asset Management, analyses whether the problems caused by the US sub-prime mortgage crisis will spark a slump and points to the investment areas which should produce good returns whatever the outcome

Everybody is talking about the credit crunch and whether we are going to have a recession.

In July and August, credit spreads – the extra yield over gilts required by corporate bond investors – increased significantly. The problems in the credit markets started when US sub-prime mortgage defaults rose sharply.

You may wonder why mortgages to Americans with poor credit records should affect the whole global economy. Well, about one in five people in the US are deemed to be sub-prime borrowers and at the end of 2006, outstanding sub-prime mortgages were $1.2trillion, 12.6 per cent of the whole US mortgage market.

Many of the mortgages are on fixed-rate deals which are starting to expire. A sub-prime borrower currently paying about 7 per cent interest on their mortgage is facing a new interest rate in the region of 12 per cent, which is a huge increase.

On top of this, the US housing market is struggling with property prices falling. This is not great news, especially if you have a high mortgage compared with your house value, as many sub-prime borrowers do.

Defaults on US mortgages have been rising. The last time that defaults rose significantly following US interest rate rises, the default rate was 10 per cent. If defaults rise to that level again – and this time it could be worse as there have been more rate increases – there will be some big losses for mortgage lenders.

Now we get to the crux of the problem – a lot of mortgage lending risks are packaged and passed on to other investors in the form of mortgage-backed securities, which are bonds are supported by the cashflow from portfolios of mortgages.

Many financial institutions, particularly European banks, have invested in these bonds, as they were perceived to offer returns above their risks. These institutions are also facing substantial losses from US mortgage lending. One German bank, IKB Industriebank says it expects to lose almost $1bn from its sub-prime mortgage exposure.

It is still not clear who is affected and by how much.

Due to the reduction in the perceived creditworthiness of banks and other financial companies, bonds issued by these institutions have been badly affected, with their credit spreads rising significantly. Related concerns about future profits also caused companies’ share prices to fall.

Why has the whole of the corporate bond and equity markets been affected? Not only is the financial sector a major part of all markets, it also supports the whole economy. The banks have now become more riskaverse and less willing to get involved in credit transactions. Bond investors are following suit, demanding a higher yield and greater protection before they will lend capital.

The availability of cheap capital through the banks and bond markets has been one of the main drivers behind the recent equity bull markets.

Cheap credit has fed both merger and acquisition activity, including private equity takeovers, and companies’ organic growth plans.

Now that borrowing is harder to do and more expensive, it is conceivable that there will be less corporate activity and lower growth.

You can see why equity markets have fallen and bond markets have priced in a high chance of a US or even global recession.

But have the financial markets overreacted?

It is easy to construct an argument for a recession. As I said above, corporate investment and therefore economic growth could be reduced significantly.

Consumer spending is also a significant part of US growth and, with the man in the street facing higher mortgage and personal loan interest rates, spending could be much weaker. This has already come through in the US second quarter growth data.

As a rise in unemployment would also affect consumer spending, US employment data is being watched closely, particularly with rumours of over 100,000 jobs being lost in the US mortgage industry in August.

With a weak housing market, lower consumer spending and lower corporate growth, a US recession would appear to be inevitable. Or would it?

Many corporate balance sheets remain strong, albeit weaker than before July, and many do not need to borrow to grow their businesses. Corporate growth will reduce will it may not be that bad and unemployment in the US has continued to be low, supporting the consumer.

Finally, and most important, central banks have been supportive recently and are expected to continue to do so. They do not like to be seen as being hostage to the markets and the Fed has acknowledged there are downside risks to growth and have signalled it will take further action if necessary to support the economy.

As a result, it is widely expected that US interest rates will be cut at the Fed’s meeting on September 18, with most commentators being confident that more cuts will follow if necessary.

Therefore, it is our opinion that the US will avoid recession but we will be watching economic data and the Fed very closely.

What does this mean for your clients? There are effectively two scenarios to consider – recession or no recession.

If, as we think, there will not be a recession, equities will do well but bond investors will also benefit both from the interest rate cuts and credit spreads tightening. Corporate bond markets are currently pricing in a high chance of a recession. If that does not happen, credit spreads should tighten significantly from their current levels, outperforming government bonds.

If, on the other hand, there is a recession, we can expect to see the Fed, and possibly other central banks, slashing interest rates.

In this scenario, equities will suffer and bonds will do very well. Government bonds will do better than corporate bonds although some value may still be found there, particularly as most of the potential damage is already priced in.

Investing in a global bond fund will allow clients to cover both scenarios and fully exploit the opportunities that arise. The fund manager will be able to allocate across the world’s bond markets and between government and corporate bonds, depending on where they see the most value.

This will ensure that clients’ bond allocations are positioned to profit from avoiding recession but also to achieve a positive return if a recession become reality.

In summary, we could be facing a recession but if the central banks act wisely, it can be avoided. Either way, bonds look like providing good returns for low risk levels.

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