THE complex nature of the US economic slowdown suggests a rapid recovery is doubtful.
Given the size and reach of the US, its impact will be felt across the globe, so an open economy like the UK cannot escape. After considering where best to invest during this difficult period, we suggest investors think carefully about the risks in t
he assets they own.
Earlier this year, more commentators accepted that a US recession is occurring. More recently, there has been a growing realisation that other developed economies, such as Europe, Japan and the UK, will be weak for some time. We expect overall growth of no more than 1%-2% in both 2008 and 2009, versus rates of up to 4% in 2006 and 2007. The next stage is appearing in the form of slower Asian exports.
The credit crisis looks more contained now. Central banks, led by the US Fed, have hurriedly cobbled together a series of tools to add liquidity to money markets, but not many households have felt the benefits yet. Where official interest rates have been cut, banks have generally been unwilling or unable to follow suit.
Large losses in some areas mean profits need to be made in others. The surge in food and fuel prices, hitting headline inflation, has ruled out future rate cuts for now, not just in the UK but in most countries.
The good news for a long-term investor is that value is being seen in some markets, such as investment-grade corporate bonds, high yielding equities and parts of commercial property. In certain stock markets, various companies offer a dividend yield higher than Government bond yield.
Value is not found everywhere. When cash has been put to work, it has often gone into the previous winners, such as emerging market equities or commodities. Our analysis suggests ongoing vulnerability, for example, because inflation pressures will be even more worrying in many of these countries than in Europe or North America.
Equity markets have recovered quite well from the lows seen in March. To bring about a sustained recovery in revenues, we need several conditions to fall into place, one being easier monetary policy actually being passed on to consumers and companies.
Companies' efforts to improve balance sheets, for example via disposing of assets or rights issues, have historically been strong signals that corporate repair is underway.
Lastly, investors would feel much more confident if the US housing market showed more signs of stabilising, but this seems some way off.
Markets assume politicians will do more to bring the credit crisis to an end. In previous banking crises in the US, Sweden and Japan, some form of public sector intervention was eventually required.
On this occasion, support could entail some form of mortgage guarantees, debt purchase or capital injections. The moral hazard and financial costs are considerable, so the debate in Congress about the Frank-Dodd proposals to give $300-400bn of capital to the Federal Housing Administration look set to continue until at least the summer.
Overall, we expect most financial markets to remain in a volatile cycle throughout 2008. A low-risk portfolio still looks appropriate. Currently, we favour bonds and cash over higher risk assets such as equities and property. While global bond yields have risen, the inflation backdrop suggests they can go higher, before eventually weaker economic activity allows the Bank of England and other central banks to cut interest rates.
This does not mean investors should shy away from equities altogether. We favour the more defensive markets, such as UK, US and Japan, over the more cyclical emerging markets, Pacific Basin ex-Japan and Europe. Meanwhile, property values could fall further in the short run, although we still expect them to deliver mid-single-digit returns over the longer term.
Overall, investors should look at their portfolio to see where it is most at risk from the issues we have outlined.
Certainly, value in many equities does exist and, as long as central banks can control inflation, eventually stock markets will recover. A diversified portfolio remains prudent but with a defensive bias towards bonds, cash and lower-risk equity markets.
Andrew Milligan is head of global strategy at Standard Life Investments.