MARKET COMMENTARY

Following a 13.5% decline in September, the UK equity market lost a further 12.1% during extreme trading conditions in October. After a series of US corporate collapses and rescues in September, some of the UK’s largest banks also faced pending disaster during the past month. On 13 October the UK Treasury announced a bailout plan involving the Royal Bank of Scotland, HBOS and Lloyds TSB.

As investors come to grips with the fall–out within the banking sector, their attention has more recently turned to the deteriorating economic backdrop. Recent data suggests that the UK has now entered a recession which may rival what we saw back in the early 1980’s and 1990’s. The Bank of England (BOE) has recently acknowledged the severity of the economic slowdown by cutting official interest rates a massive 1.5%. We believe that further rate cuts are ahead and that policy easing next year will help support sentiment and the UK equity market.

The volatility of US stocks has intensified dramatically over the past few months. The Chicago Board Options Exchange Volatility Index (or VIX), commonly referred to as the ‘investor fear gauge’, shows the market’s expectation of volatility tripling since the end of August.

The outlook for US stocks hinges heavily on the housing market. That’s because banks cannot quantify their losses while house prices keep on falling. With the supply of new homes coming down considerably in recent months, it appears likely that house prices will fall next year but stabilise in 2010, allowing banks to become more confident about lending.

Importantly, US firms have been actively cost cutting and increasing productivity throughout this turbulent period, which has put them in a far better position. Once demand for their goods and services picks up again, it’s likely lead to a significant boost to profits.

As measured by the DAX index, the German equity market lost 14.5% in the month of October and the French CAC 40 index fell 13.5%. As a whole European equities (according to European total market returns from Datastream) were down 23.2% for the month of October.

Stock prices sank and investor confidence was eroded as Belgium’s largest bank (Fortis) and Germany’s second–largest commercial property lender (Hypo Real Estate) were forced to seek assistance from government.

While it took longer to find its way to Europe, the credit crunch has now settled in. The news on the economic front is also grim. Recent data indicate that Europe is unlikely to escape an economic downturn in 2009, with a large hit to growth coming from declining export levels from developed European markets to Eastern Europe.

After falling 14% during September, the Japanese share market declined 19.7% in October. Losses have continued into November as a slowing global economy has been feeding through to Japan’s exporters with shares in companies such as Toyota Motor Corp plunging following a 69% decline in quarterly net income.

While Japan is not immune to the global economic downturn, the banking crisis has not had as severe consequences in Japan as other developed markets. This is due to the fact that Japan already experienced a significant adjustment during the Asian financial crisis of the late 1990’s. The high profile bankruptcies in 1997 triggered high savings levels which remain today. As a result, many Japanese banks are awash with cash rather than highly leveraged like their peers in the west and have been opportunistically looking to invest in struggling corporations.  

Economic data for emerging markets was particularly bleak during October. We saw industrial confidence in China fall back to lows not experienced since mid–2002 and the Chinese PMI – a key survey of managers in the manufacturing sector – slumped, indicating that business activity has cooled substantially. Having performed well despite the global financial crisis, there were also signs last month that the Turkish economy is stalling. Business surveys released in October showed a decline to levels not seen since 2001.

While emerging economies initially held up well while the developed economies went into decline, most recent data indicates that a slowing global economy has started to spill over to countries that rely heavily on trade. As a result of this deteriorating economic backdrop, emerging equity markets have suffered some sharp declines. In China, the Shanghai A–share index declined 24.6% during the month of October, the Indian stock market was down 26% and in Russia equities fell 36.2%.

The good news is that central banks in the region have started easing monetary policy to stabilise markets and stimulate growth. The People’s Bank of China recently cut official interest rates for the first time in six years. Emerging markets have expanded rapidly over the past few years and have grown considerably in their contribution and importance to the global economy. While a weaker outlook for the global economy is bad news for emerging economies as it lowers commodity prices and global trade (detracting from key exporters in the region), the underlying structural dynamics (particularly the industrialisation of China) remain in place, leading to strong long-term potential for equity markets in the region.

The UK all commercial property total return was a negative 4.8% in Q3, incorporating a further 6.2% fall in capital values. The deteriorating economic backdrop has lead to weaker occupier markets, particularly for Central London offices. Investment transaction volumes remained low, with buyers remaining extremely cautious and deals proving more challenging to agree and complete. There is likely to be continued pressure on property values in Q4 2008 and potentially for much of 2009. The scale of downward pressure is likely to be driven by developments in wider asset and credit markets.

However while the prospects for rental growth over the next 2–3 years are relatively modest, current valuation yields (as of end Q3) offer the prospect of a medium term (5-10 year) nominal return of 7–8% pa. Investors who allocate funds and transact opportunistically over the next 6-12 months should be able to capitalise on pricing that offers returns some way above this level.