Overview

This has been an exceptionally difficult year for the world’s financial markets. Equities remain on a rollercoaster ride, and the global credit crisis is still unresolved. But the continued market convulsions make it even more important to take a step back and take a considered view about what exactly has been going on, and how the investor should respond. The extended length of this annual Signpost facilitates such analysis, and we hope that it provides an interesting and informative read. You may however find that a good starting point is the four page Executive summary, which presents our key conclusions in an easily accessible form.

Some fundamental issues around the credit crisis remain misunderstood. So Signpost starts by looking hard at the damage, to both balance sheets and investor sentiment. Next we examine how the world’s economies might react to a recession in the US, were that to happen. Although many commentators expect a US recession, it is not our most likely scenario, but rather a major potential risk.

Getting a handle on the magnitude of the credit crunch illuminates several points and should give some relief to frazzled investors. The actual size of sub-prime debt is not large – at least in relation to US credit obligations overall. However, collateralised debt obligations (CDOs) will amplify the impact of defaults and arrears on the financial sector. Losses to the banking industry as a whole range from US$150-350bn and losses outside the banking area are a similar amount. But these are very manageable losses for a well-capitalised and diversified industry.
But perhaps a more pertinent question would be to ask what would happen were US house prices to fall sharply. In fact studies suggest that the impact on higher grade tranches of debt would be small, if any. We do, however, point out that lower house prices would have a strong effect on the demand for credit, and on consumption. Past experience of housing crises suggests that they can take time to unfold, and have severe consequences.

Another important factor not often discussed is the incredible restorative powers built into a hyper-dynamic and flexible economy and financial sector. The world’s universal and investment banks, hedge funds and the markets themselves are much less “brittle” than they proved in past crises. Enormous sums have been invested in financial technology research and development which will help institutions respond to this crisis. Another factor absent from previous periods of financial stress is the rude health of emerging markets. Additionally, the world’s central banks have already demonstrated a much greater willingness to take action than in previous downturns. Macro-economic data from the US has been relatively strong, and our recession probability models are still upbeat. So we still put the chance of a US recession at 40% – with our central scenario being continued, if much slower, growth.