What a Terrible Year

What a terrible year it has been for investors. What a shocking month. What an awful week (week ending 10/10/08). Chris Caton, Chief Economist at BT says that he doesn't anticipate a worse week in the rest of his working life! Clearly market participants have convinced themselves that the recessions around the world are going to be both long and hard, so they are withdrawing now. They may be right about the severity of the downturn. On the other hand, we may look back at the "Panic of 2008".

This extreme volatility has affected other markets also. Who would have believed three months ago, when oil was $147 a barrel, that it would now be less than $80? Or, perhaps most amazingly, that the Australian dollar would have fallen from an over-valued 98 cents to a ludicrous 65 cents? Both of these extreme movements reflect a reassessment of likely world economic growth in 2009. With so many OECD nations already experiencing close-to-zero growth, it is beginning to sink in that we may be on the brink of world recession. It is clear that we are somewhere that we have never been before. Financial systems around the world are "locked up", with institutions completely unwilling to lend to each other for fear of what could happen next. The world economy is caught in a brutally vicious circle.

The remedy is a circuit-breaker of some kind, and policy-makers around the world are desperate to find one. In fact, it will take more than one. We will see interventions in the days and months ahead that would never have been imagined in a functioning capitalist system. Bank deposits have been guaranteed in Australia, and governments will purchase equity in financial systems all over the world. We will see stronger government controls-first to stabilise the situation and then to ensure that it never happens again.

So what does this mean for financial markets? Trying to pick the timing of a halt to the current carnage is difficult. But I would make the following points. The fall in the current bear market in shares is already bigger than the average for such episodes. The Australian market is more than 40% below its peak; the average bear-market fall is about 33.3%. Also, if measured by conventional price/earnings ratios, share markets around the world are very cheap right now. Price/earnings ratios can mislead; they are only as good as the underlying earnings forecasts. But right now, world equity markets would be fairly priced (neither cheap nor expensive) if earnings were to fall by more than 40% next year.

One rarely sees sustainable recoveries in share markets until economists and analysts start to factor in economic recovery (this process precedes recovery itself by several months), and we are months away from that. So we seem to know the following: markets are cheap right now and there is a sustainable recovery out there somewhere. We just don't know whether fear and pessimism will become even more dominant in the weeks ahead. That said, there has to be a chance of a short, sharp rally in the coming weeks if market participants come to the conclusion that the market is oversold.

And what about the currency?

The fall in the currency has been amazing. In July, when the Australian dollar was at 95 cents, we estimated its "fair value" at 90 cents. Now, our fair value estimate is about 75 cents, compared with an actual exchange rate of about 65 cents. So the currency has gone from too expensive to way too cheap. This means that it is likely to claw its way back up to the high-70s over the months ahead.

Chris Caton
Chief Economist
BT Financial