Michael J Howell: Reasons to be cheerful: pessimism is not always the best predictor

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The Independent Online

Christmas cheer was left on the shelves this year. Scrooge is back. Or, so it would seem, if only the opinions of financial markets counted. In fact, we have never seen such pessimism among investors looking into the new year. After shaking their chicken bones, the consensus of American economists puts 40 per cent odds on a US recession next year. What would that mean for the beleaguered housing market and sub-prime woes? Surely, sitting on cash looks king again?

But hold on. Internal indicators of investor sentiment from my company, CrossBorder Capital, show some of the weakest readings since the bear market lows of 1982 and 2001. Plainly a lot of bad news is already in share prices, and history shows a consensus this strong is never right. Not surprisingly, America's shrewdest investor, Warren Buffet is ploughing his money back into the stock market. Financial markets tend to bear the impression of the thing that last sat upon them. Sub-prime credit was a 2007 problem. It is unlikely to be a major issue again in 2008.

Central to our upbeat view is the fact that central banks have now become part of the solution to the credit mess, rather than part of the problem. Markets are in the midst of a typical liquidity crisis not a solvency crisis. Central bankers were to blame, not the credit rating agencies. Central bankers have not only recently shown poor short-term management, but, from a longer perspective, they seem to have been planning this crisis for two decades; in fact, ever since they de-regulated financial markets and switched from control over reserve requirements and the volume of credit to capital ratios and interest rate targeting.

The history of the last 20 years is a history of rapid credit growth; the increasing lack of central bank control over credit, and policy-makers' frequent "reaction" to credit crises. The latest 12 December 2007 "reaction" from key central banks including the Bank of England and America's Federal Reserve is a "new" auction-based, discount window through which policy-makers can chuck out liquidity. Reassuringly, our data shows that the Global Liquidity Cycle a measure of new credit taken up is now rising again strongly. For example, our aggregate 80-country liquidity index hit 58.4 per cent ("normal" range 0 per cent to 100 per cent) at end-November 2007, from 53.9 per cent in October and 31.4 per cent at end-2006. [See chart] Momentum, a measure of the rate of change of liquidity, hit a whopping 91.4 per cent. Yet today's strong rebound hides two years of tight financial liquidity from mid-2004 to mid-2006 when central banks hit the brakes.

The subsequent collapse in US (and now other) housing, and the gathering evidence of economic slowdown prove it. Moreover, defaults typically occur just after the low point of the liquidity cycle and so trigger renewed easing. As such, today's US sub-prime problems can be compared with the US Saving and Loan and Japanese banking crises in the early 1990s; the UK banking crisis in 1974; the failure of Continental Illinois in 1984, and the bankruptcy of the US companies Worldcom and Enron in 2001. Yet, steeled by more liquidity, markets quickly shook off each crisis.

Are today's problems any worse, or are they largely confined to the investment banks, the hedge funds and the estate agents? We stand at least four months from the August credit hiatus and there appears few signs of any collapse, crunch or even a significant slowdown in America's credit growth, with two exceptions.

First, the asset-backed commercial paper market (the source of funding for the nefarious off-balance sheet activities) has collapsed. Second, the pace of American credit card loans, auto loans and securitisation have all slowed to either zero or slightly negative growth rates but they had been slowing down for six to 12 months before the crisis hit. Notwithstanding, these weak components, overall US credit has expanded and at an above-trend 10 per cent annualised monthly clip since August! This may reflect calm before the storm perhaps the drawing down of previously agreed credit lines or it may not! Then again, remember America now has to share her economic podium with the emerging markets. Even these decent US credit increases make-up only 15 per cent of the growth of world credit over the last year. Our latest data shows emerging market loans grew by an annualised 38 per cent clip in the three months to end-November: a rate that has also accelerated since August. Moreover, set against total worldwide credit of $65 trillion (32trn), the estimated $300 billion of US sub-prime losses, or 0.4 per cent, look small. Thus, despite the headlines, the world's credit mechanism is still pumping out loans and not yet spitting out bolts.

Looking ahead, the most important issues for 2008 are almost certainly not US sub-prime-related. Rather they concern, firstly, China. The engine of world growth is likely to deliver another jaw-dropping, double-digit GDP growth rate in 2008, the year of the Olympics.

Secondly, US inflation. The basis of financial market valuation will likely remain sticky at 3-3.5 per cent, proving more an annoyance than a problem.

Thirdly, the US dollar. The integrity of the world's main store of value should be underpinned by solid export gains which should vastly improve sentiment.

China should see continued high GDP growth through 2008. The Olympics will support activity, but given the importance of credit it is reassuring to see both Chinese Central Bank liquidity and private sector liquidity growth staying at elevated levels. If anything, we should worry about potential Chinese economic overheating in 2008 and the effect that this could have on world inflation and resource prices. The nettle that China's policy-makers have to grasp is whether they can or should tighten to avert faster inflation next year at the very time that their economy comes under the world's media spotlight ahead of the August games? Our guess is problems will be buried until 2009. A fast-growing China means continued low world real interest rates and upward pressure on commodity prices.

Meanwhile, America's trade numbers are already looking better. If the recent jump in net export volumes is extrapolated forward, America's trade deficit could disappear entirely within two years. Fuelled by the cheap US dollar, soaring exports are four times as important to the US economy as the skidding housing industry.

The flow of funds counterpart to this trade improvement is a sharp rebound in US private sector liquidity. This is already under way. Not only does better American private sector cash flow augur well for future corporate profits, but it suggests that the US dollar could rebound sharply through 2008.

Where to invest in 2008? We use the Global Liquidity Cycle to guide us. Liquidity is rising and looks unlikely to peak before late-2008 at the earliest. Remember that liquidity is a leading indicator. It leads economies by 12 to 15 months; stock markets by around six to nine months and is usually three to six months ahead of fixed income and currency markets. All in all it tells us that 2008 will be better for financial markets that 2007, but economies will be a little worse, especially during the first half-year.

Our liquidity data shows greatest conviction towards lower interest rates and yield curve steepening; US dollar rebound and, thirdly, persistent low real bond yields. Equity markets will rebound if the US economy slows but avoids recession, and if the Chinese economy maintains its momentum, and provided that inflation remains quiescent. Since we have few reasons to doubt this holy trinity, we have maintained our equity exposure. However, it is skewed geographically towards the US and UK equities and a few emerging markets, such as Mexico and Taiwan. We are reassured by the fact that investors' exposure to US and UK equity markets is at the same minimum levels as at the bear market lows of 1982 and 2001. Hopefully, this consensus will show the same prescience. So, 2008 is unlikely to be another sub-prime year: pessimism is never the best predictor.

Michael J Howell is managing director of CrossBorder Capital, a London-based investment adviser

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