Equity Market Views: November 2008 - OCBC Wealth Management

Market not out of the woods yet

28 October 2008

Widespread panic and the rapidly collapsing global credit systems provided enough catalyst for the central banks around the world to dish out costly but necessary rescue packages in a coordinated fashion in October.

Trillion-dollar rescue packages were unveiled in Europe while the U.S. said that it would buy stakes in banks and purchase troubled assets from financial institutions as part of its US$700 billion bailout plan.

The rescue packages in Europe included guarantees that would cover deposits and lending between banks, and capital injection, which in some cases would result in governments becoming significant shareholders of financial institutions.

These measures were needed to ease the gridlock in credit markets and restore confidence in the global financial system.

Credit markets have not normalised

There are signs of a thaw in credit markets as the London inter-bank offer rates (Libor) have eased.

Although fears have eased that the global banking system will collapse, credit markets may remain relatively tight as financial institutions are guarded about the outlook and are still worried that there could be more surprises in the offing.

Also, banks will need time to recover their substantial losses and recapitalise their balance sheets. Hence, they are likely to stay cautious and may not resume normal lending activities anytime soon.

More unwinding likely to follow

Despite all the central banks' efforts, there may be more capitulation in equity markets as global leverage built up over the last ten years is unwound.

Already, we are starting to see signs of forced selling and de-leveraging in the US$2 trillion global hedge fund industry. As the funds' returns suffer, investors pull out money while banks and prime brokers are cutting their leverage and demanding more collateral. As a result, hedge funds are forced to sell off assets to cover redemptions to meet margin calls.

The U.S. housing slump story is hardly concluded as well. U.S. home prices are still falling and the rate of mortgage foreclosures is expected to rise in the coming months, especially when adjustable-rate mortgages are reset. Over the next two years, credit-rating agency Fitch has estimated that a sizeable US$96 billion worth of adjustable rate mortgages would be reset to higher interest rates.

Companies will also continue to unwind their debt holdings and investments, purchased with the help of borrowed money, which will further push down the market prices of many assets, including equities, causing yet more losses for investors. The ability of companies to refinance and have access to credit will also be the difference between staying afloat and falling off the cliff. As inter-bank rates remain relatively elevated, many weaker companies are expected to be pushed over the edge.

Economic and earnings outlook to worsen

Even if the rescue efforts help to calm nerves in credit markets and jittery investors, it may not be enough to prevent the global economy from slipping into a recession. Already, there are signs that the massive asset write downs and credit losses among global financial institutions, which stands at about US$650 billion so far, is weighing on the global economy and corporate earnings.

Also, the write downs may not be over and global financial institutions may need to make more provisions as the value of mortgage-related assets on their balance sheets could diminish further and losses may need to realized if these assets are sold at current market values.

Given the risk of a sharp global economic slowdown and possibly a recession, corporate earnings forecasts which appear to be too optimistic, may miss the mark in the coming quarters, and this is likely to weigh on equity markets as profit estimates are revised downwards.

In addition, against a backdrop of tight lending conditions, companies are bracing themselves for a sharp global slowdown and have put expansion plans on hold.

Full recovery may take several months

Fears that the global banking system will collapse has eased, but financial institutions are still guarded about the outlook and remain cautious about extending loans.

The financial crisis is now starting to hurt the real economy and corporate earnings, and deep recession cannot be discounted.

Financial institutions, which provide “fuel” to the economy, are badly hurt and will need time to recover and resume normal activities.

Given the above backdrop, it could take several months before the global economy returns to normalcy.

What should investors do?

Investors should not throw caution to the wind, and if they are looking to invest, they should do so gradually over the next few months as there is a risk that markets could weaken further in due course.

Time diversification aside, investors should also stay diversified across asset classes to protect their downside.

Those looking to nibble should be mindful that full recovery may not take place for quite a while. Hence, they must be prepared to invest for the long haul.

Given the current environment, equity investors must clearly have a strong risk appetite as markets are expected to stay very volatile.

Overall, equities remain a good long term bet and markets in Asia and emerging regions should resume their uptrend once the dust settles.

Performance of Key Stock Markets

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