Investment View

Monthly Investment View Update - December 2008

As part of our continued commitment to keeping you informed on the outlook of the global investment market, we've developed this new section on our website to keep you updated. Featured on this page, you'll find a global economic overview and commentary on our overall investment strategy.

The worsening growth outlook in most regions over recent months has shifted investors' focus for 2009 on to the prospects for deflation - especially in the US, where October's Consumer Price Index (CPI) inflation ex-food and energy was negative, for the first time since 1982.

Average annual breakeven inflation rates from the US Treasury Inflation-Protected Securities (TIPS) market are currently close to zero. This suggests that investors are expecting a Japanese-style outcome for the US economy, with GDP and prices remaining fairly static over an extended period. Interest rates have been lowered by central banks around the world, and expectations of further rate cuts have resulted in a steepening of yield curves in all major bond markets.

Quantitative easing by the US Federal Reserve (Fed) has brought the effective Fed funds rate down below the Fed's stated target since mid-October. This has been a positive development so far, as it has led to looser-than-intended official monetary conditions. But it shows that the US is already close to being in a liquidity trap, where interest rate cuts will no longer be able to stimulate economic activity.

The decline in industrial output has accelerated during the final quarter of 2008. In part, this reflects the cyclical slowdown in activity already seen in forward-looking indicators for the sector. Yet the slowdown has also been exaggerated by the impact of Hurricane Ike, which served to reduce industrial output in the US during the early weeks of the quarter.

In our central case scenario for US GDP growth, the current quarter is forecast to mark the trough in growth, with easier monetary and fiscal policy increasingly boosting activity during 2009. However, we still expect growth to remain negative in the first half of the year and to stay below the trend rate until 2010. That would be a longer-than average recession, keeping downward pressure on core inflation throughout 2010.

Downward revisions to earnings expectations have reflected this worsening economic outlook, with an unusually large 85% of all developed and emerging market earnings revisions now being downward. An analysis of expected earnings relative to their long-term trend suggests that, even allowing for a deeper-than-average recession, most of the negative earnings revisions have already occurred. However, some scope remains for further downside surprises heading into 2009.

The regional performance of equity markets has been consistent with previous slowdowns. Traditionally high-beta* markets, such as the Pacific Basin and emerging Asia, have underperformed both the US and the UK, even though the latter have especially indebted households that are consequently exposed to de-leveraging in the real economy.

Liquidity developments in financial markets have been mixed over the past month. On the positive side, lower policy interest rates and reduced inter-bank lending spreads have brought US dollar LIBOR (London Interbank Offered Rate) below its level before the failure of Lehman Brothers. But this hasn't been reflected in improvements in the wider credit market, as the US Treasury indicated it was backing away from an assumed commitment to use the Emergency Economic Stabilisation Act to purchase mortgage and other asset-backed securities. Indeed, investment-grade spreads have moved back to their previous wide levels of mid-September.

* Beta is a measure of a stock's volatility in relation to the market as a whole.

The opinions expressed here represent the house view at the time of preparation and should not be interpreted as investment advice. If you do require investment advice please speak to a financial adviser. As a Private Banking customer your relationship manager can arrange this for you.