Hamish McRae: We may be close to bottom of bear market but US remains a concern

There has, of course, been a sudden downward lurch in financial sentiment over the past few days, reflected in the fall of both equities and in the dollar, but there has been very little parallel evidence of worsening economic conditions. So, is this just another example of markets catching up with what was already known or is there something new and more sinister going on? I think it is mostly the former; but there is a danger of the latter.

Start with share prices, which have bombed. Here in the UK, they have fallen to such an extent that a yield gap has opened up: the prospective dividend yield on the FTSE 100 is now higher than on ten-year gilts. This has not happened for any length of time since the late 1950s, though it has nudged higher for a few weeks from time to time. Before the late 1950s, in fact right back through the 19th century, equities generally gave a higher yield than gilts on the grounds that they carried higher risk. Then, as people became aware of the great inflation of the second half of the last century, yields on fixed interest securities rose to compensate for the loss of real capital value, while yields on shares fell because people reckoned to get part of their total return in the form of a rising share price. The result: the reverse yield gap became the norm.

But during the early 2000s, inflation remained low and bond yields fell; meanwhile, we had the last bear market in equities and briefly in 2003 we went back to a yield gap again. But the crossover lasted only a few weeks and actually was a signal for the next bull market, the one that ended last year. So a question: is this crossover the signal that markets have caught up with the toils and troubles ahead and we are therefore close to the bottom of this bear market? Or, alternatively, will the forthcoming downturn cut company earnings so much that further falls will be in store?

Of course, none of us can know the answer but I thought you might like to see the graph at the top left, which shows the cross-over. Mike Lenhoff, at Brewin Dolphin, who drew my attention to this, argues there is real value in the market. The dividend yield is now over 5 per cent. But should we take that as the fundamental valuation or take the price/ earnings ratio? Lenhoff prefers dividends. He says: "The forward p/e ratio for the FTSE 100 has dropped to around 9.5, which is what it was at the end of 1990, at the time of the last major recession in the UK. However, with corporate earnings heading downward and estimates being cut, there is distrust in the p/e ratios. Better then to trust the dividend yield."

There is a further point to be made here. If the UK market which, remember, is really a global market since more than half of earnings come from abroad, is back to the p/e of 1990, one could say that it is consistent with a downturn of similar magnitude to that of the early 1990s. I have long felt that, looked at worldwide, this downturn will be somewhere between that of the early 1990s and the early 2000s: better than the former but worse than the latter. If that is right, then most of the bad news will be in the market already.

Most but not all? There have been two particularly unsettling developments the past week, one in Germany, the other in the US.

In Germany, there has been a sudden downward lurch in business confidence. You can see that in the next graph, bottom left, which shows the index of financial confidence from the Mann-heim-based ZEW Centre for European Economic Research. It is back to the level of 1993, when the German economy was heading into its early 1990s recession. (Their recession came later than ours because in the 1990/1991 period, when we were heading down, the German economy was boosted by unification.) So I suppose you could say that it too was signalling a 1990s-style downturn. Until now, the German economy appeared is good shape, buoyed by strong exports. But the soaring euro has hammered profitability and may start to dent demand. The next graph, centre, shows how the earnings outlook for the motor industry has plunged, something that the markets have belatedly appreciated.

UBS, which did these graphs, reckons that the fall in sentiment is not just because of the decline in German economy activity but is also the result of the troubles of the US banking system. In other words, the problem is not just a home-grown one but an indication of the contagion from across the Atlantic.

If that is right – and I think it is – then the clue to a change in sentiment both in Germany and here (and everywhere else, actually) will be what happens in the States. What can we sensibly say about that?

The bail-out of Freddie Mac and Fannie Mae is enormously important because it goes to the heart of international confidence in the US Federal government and the dollar. The lenders' liabilities do not carry a formal Federal guarantee but they have an implied one. Foreign governments, including foreign central banks, hold large quantities of these two agencies' debt: perhaps 20 per cent, or $1,000bn, of it. They hold it because it gave a slightly better return than pure treasury stock. If the rescue were botched and this debt started to slide, it would be the gravest statement about the US Federal government's creditworthiness.

You have to remember that every month the US has to persuade foreign holders to buy US securities simply to cover its trade deficit. Until recently, there was a foreign inflow into US commercial debt. But that has now gone negative, as the final graph shows. I doubt anything significant, rescues of US banks aside, is coming into US equities. So, in all probability, all the money being invested in the US is now going into Federal securities. Were the Federal government perceived not to support Freddie Mac and Fannie Mae, then we are into something really serious. The fall of the dollar that has happened so far could go much further.

Some argue that were the dollar to fall further, that would teach the foreign investors in the US a lesson. China should not have allowed itself to build up such a large trade surplus and hold down the yuan to such an extent. If the dollar falls further, so be it. That is the tough-minded response. There have been runs on the dollar before, for example in the early 1980s. But if we go down that road, there will be a lot of economic disruption worldwide, more disruption than there needs to be, and we really would be into an early-1990s world recession.

The US financial establishment knows this. On Tuesday, we had the assurance of Henry Paulson, the US Treasury Secretary, that the administration would rescue the twin institutions, though that plan has run into strong criticism in Congress. Yesterday, we had Ben Bernanke, chairman of the Federal Reserve, again telling Congress that his priority was restoring financial calm. One assumes that between them, and with the support of the Securities and Exchange Commission, they will cut the mustard. One assumes ...

We have been here before. Those of us with long memories will recall Paul Volcker, then head of the Fed, patching together a support package for the dollar. Eventually, calm will be restored. The question that no one can answer is whether this crisis of confidence in US banking will be coped with reasonably swiftly or whether there will be several more months of this. And that is why the markets are seriously twitchy.

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