It would have been difficult for you not to have noticed the turmoil that has hit investment markets this year. From their peak in October 2007, global share markets plunged, as investors around the world became worried about a global credit crunch and as the US economy - the bell weather of all economies - looked certain to be heading for recession. As we write, global share markets are 22.2% lower from where they began the year, having fallen sharply again during the last few days as a number of large US financial companies have struggled amidst the harsh environment. New Zealand investors were not immune from global financial market turmoil, with New Zealand shares 21.7% lower over the same period. Both during the market's declines and throughout this period, volatility has increased, with markets rising one day and falling back down the next. This has created a lot of uncertainty and investors have been subjected to a rollercoaster ride.
So what has driven the market's nervousness? Well, most commentators would say that the market's woes stem from the rise of the sub-prime mortgage market in the US over the last five years. With economic conditions having been so good and house prices booming, this had led to the availability of cheap credit and borrowers (including those with poor credit histories) were able to borrow well beyond their means. But, as US housing market slumped, a number of these mortgage companies began to feel the pressure as borrowers defaulted on their loans, resulting in the ensuing credit crisis.
As news spread that a number of financial companies were exposed to the problems resulting from this, global share market sentiment took a turn for the worse. Shares in financial companies, such as banks, were sold down sharply, dragging other areas of the market down with them. With house prices falling and a number of large US financial institutions in trouble, it was little surprise that this had a knock-on impact elsewhere on the economy, prompting fears that its economy was heading for (if not already in) recession.
In New Zealand, while share markets have taken their direction largely from what was happening overseas, events at home have also clouded the horizon. New Zealand growth has slowed dramatically, as the brakes have gone on a once raging housing market and as interest rates kept on creeping upwards. In fact, interest rates in New Zealand are amongst the highest of all countries in the OECD and this has made the impact on New Zealand households particularly tough. High mortgage rates and the slowing housing market have resulted in weaker consumer spending, while high borrowing costs and the strong dollar have made conditions especially tough for our companies. But it is not just worries about the economy that have hit sentiment here in New Zealand. Undoubtedly this has been further dented by the ever-growing number of finance company collapses, which now include a number of high profile names.
And as if that wasn't enough, the spectre of inflation - a worldwide phenomenon - has also started to threaten the global growth. The main driver of inflation globally has been oil prices, which rose to new record highs on the back of soaring demand from the still-growing Asian economies. In June, prices hit over US$145 a barrel, far beyond the levels ever imagined at the start of the year.
If you have investments, no doubt you've been sitting tight, wondering whether there is any end to this ride. With financial market turmoil being front-page news on almost a daily basis, many New Zealand investors may justifiably have concerns as to where to from here. The pessimists out there are all doom and gloom and the events of the last few days would certainly suggest they have every right to be glum. While we wouldn't go so far as to call the bottom of the economic cycle just yet, we do believe that some of the preconditions for an economic recovery are beginning to fall into place.
Most notably, oil price have fallen sharply off its highs, with the price of a barrel of oil now trading at around US$90. This, accompanied by the general slowdown in global growth, should help to lower inflation concerns and pave the way for lower interest rates around the world, which previously central banks had been unable to do for fear of further stoking inflation. In turn, this should help underpin any economic recovery as we head into 2009.
That said, there remain a number of risks which we believe may prolong the current uncertainty around the global economic outlook. First and foremost, asset prices continue to fall sharply. US house prices are plumbing new depths and we are now beginning to see evidence of similar house price collapses in other major economies. Share prices also continue to fall sharply, having plummeted more than 7% this week to reach new bear market lows, as news broke of yet another collapse in a large US investment bank and as the market braced itself for its next big casualty. This kind of environment is likely to make both consumers and business even more cautious about spending and investing, and less likely to be able to borrow against their assets in order to do this.
Meanwhile, credit conditions have continued to tighten as turmoil in the US banking sector has intensified. This means that lower official interest rates may not necessarily be passed onto consumers and companies through lower actual mortgage and borrowing rates. In addition, banks may have less capacity to lend money out while they work to repair the damage that the credit crunch has already inflicted on their balance sheets, and this could inhibit any economic recovery.
The other big downside risk that we see is around company earnings and profitability. Current earnings forecasts appear to have factored in the likelihood of a reasonably quick economic rebound and a return to some sort of normality in earnings growth. While these rather optimistic earnings forecast make equity market valuations appear attractive, cheap valuations only stack up if company earnings forecasts materialise. Our view is that current earnings forecasts remain too optimistic given the potential for a more drawn out recovery and so the risk remains for further downgrades as companies continue to face pressure against a backdrop of falling profit margins.
So the risks to the global economy remain very real, but where does New Zealand stand amongst all this? Well unfortunately, as we have seen this year, the New Zealand economy does not operate in isolation from the rest of the world. And while there have been some tentative signs indicating a more positive economic backdrop for the fourth quarter (such as improved consumer and business confidence), we must remember that these have been from deeply depressed levels. Our view remains that the New Zealand economy will continue, at least in the near term, to face substantial headwinds arising from tight global credit conditions, continued falls in global asset values and existing inflationary pressures.