It would be foolish to underestimate the impact of the credit crisis on global markets but equities whose valuations discount a full-blown recession could prove to be attractive investments on the assumption that a hard landing does not materialise. There is clearly significant potential for a strong bounce on signs of a recovery.
The New Star fund of funds team has exposure to US homebuilders but we have not yet re-entered the financial sector. There may be short-term trading opportunities but the sector will have to endure a prolonged deleveraging before it can return to health.
There are a number of reasons to anticipate the beginnings of a recovery. In March, the Federal Reserve took dramatic action in its efforts to stem the credit crisis by financing JP Morgan’s rescue takeover of Bear Stearns, which has an estimated £13tn involvement in the troubled derivatives market. The move helped restore some calm to the US financial market and the broader financial system. It was also a signal of the Fed’s willingness to do whatever it takes to support the financial system and get the economy back on track.
The rescue was followed by Lehman Brothers raising $4bn and Wachovia $7bn through rights issues that should help contribute to a thawing of the liquidity freeze. US banks and securities firms have raised or announced plans to raise at least $163bn in capital since July while Royal Bank of Scotland set the ball rolling in the UK with a £12bn rights issue.
History shows that stockmarkets rise over the long term and bear markets typically end in the middle of recessions. The market is a discounting mechanism and typically anticipates economic events by between six and 12 months. If a recession is confirmed, it is likely that it began in the fourth quarter of 2007. This would mean it is up to six months old and could be nearing the mid-stage, when the germ of a fresh bull market typically forms.
There is tentative evidence that the worst of the credit crisis is behind us but economic news over the coming year is likely to remain bleak as the lagged impact of the crisis catches up with earnings. Markets should begin to anticipate better times and some of the strongest gains are often obtained by early investors in sectors that are out of favour.
Mark Harris heads the fund of funds team at New Star Asset Management