The IMF Report on the world economy has caught up with private sector forecasters at last. After a poor two years first ignoring then worrying about the scale of the downturn, the IMF now expects a resumption of world growth of around 3% next year, with the Asian powerhouses providing the lead. Let’s hope they are right this time. If world growth disappoints, world share prices are now very exposed.
We are living through a period when the economic news is being forced to catch up with events in financial markets, by the strong and favourable impact of easy money on asset prices. As a result of the rush into risk of the last half year, shares are now much more expensive than last March when they hit a bottom as fear and tight money gripped markets in a vice like grip. Commentators are dashing to discover good news to justify the prices.
The IMF Report reminds us that the banking crisis is not yet resolved. Whilst few now expect further collapses of major banks, there is likely to be a long period of work out whilst the banks adjust to the tougher capital requirements being placed upon them. The Report draws attention to the particular problems of the UK, where a large banking system relative to the size of the economy, co-exists unhappily with a very overextended consumer sector trying to repay debt, and with a government sector building up its own borrowings at a huge pace. The existing banks do not have the capacity to advance all the money the economy needs.
The temporary expedient of Quantitative Easing cannot go on forever. The present system ensures plentiful funds for the government bond market, allowing the state to borrow as much as it likes. Market interest rates for the private sector are much higher than the indicative rates set by the Central Bank. As the IMF rightly warns for the UK “non financial private sector credit will contract or barely grow during the remainder of 2009 and the first part of 2010” as all the pressure is placed on the private sector. The banks are being forced to restrict private sector lending to improve their capital ratios in a hurry. They are taking advantage of the current conditions to increase margins on what new private lending they do undertake.
In the USA the improvement in share prices now takes the S and P to a position where it is only producing an income yield of 2.4% and is valued at 16.9 times earnings. We do not think this represents good value for investors, given the real problems that still lie ahead for the US economy. We recommend low or no exposure to US shares at these levels. In the UK the yield is a better 3.33% and the earnings multiple a fairly demanding 13.27, but the problems of the UK economy and currency are more extreme than the US ones. It is true the main companies are global and have a mixture of businesses and currency receipts, but why not invest completely abroad if you are concerned about the specific UK risks.
Our preferred investment areas of China, India, the rest of the Far East and emerging markets are becoming very fashionable. All the time easy money flows it has to go somewhere. We suspect it will fuel even stronger performances in markets where there is a good prospect of better growth to start to lower earnings multiples again as companies make higher profits. So we recommend running positions in these areas, but are happy to hold a bit more in higher yielding corporate bonds to cut the risks. The higher the markets rise the more risk there is. We need to remember in these heady days that the banking problems are not yet solved. The world is making slow progress in tackling the huge imbalances between the exporters and the importers, between the saver and the borrower economies. There could be more pain ahead, especially when they start to switch off the easy money.