Markets - is the downturn over?

After a turbulent period for markets, Paul Niven, Head of Asset Allocation at F&C Investments provides an update on the outlook for markets.

In particular, he looks at the impact of problems in the US sub-prime market. While he concludes that recent jitters in global stock markets are merely a correction in the context of a long-term bull-market, he does nevertheless warn that a secondary downturn of panic selling cannot be ruled out:

Paul Niven, Head of Asset Allocation at F&C Investments, says: "Following the sharp sell off which gripped equity markets two weeks ago, a level of calm seems to have returned, with greater stability in prices, and some tentative upward momentum being re-established in major indices. Having initially scrambled for justification for the sharp declines in prices, focus has resolutely turned from the carry trade to the sub-prime market in the US as the cause of recent woes.

"This issue relates to lending to individuals with low credit ratings in order to fund property purchases in the US and is symptomatic of the easy credit conditions which have prevailed in recent years across many major western economies. With easy credit and lax lending standards, demand for debt has increased to fund purchases of assets which had, until recently, fuelled growth in house prices and, in turn, consumption in the US. With rising rates and resets of mortgages lending rates, however, the perils of dubious lending practices are now coming home to roost with rising delinquency rates and defaults in the subprime, low credit quality areas.

"There is little doubt now that the subprime crisis is a serious problem affecting the US. For economists, the question is whether this issue can be contained, or whether it will lead to a marked downturn in the US economy. The outlook for the US housing market, which had been showing tentative signs of a trough, has clearly now worsened with a further downturn in housing starts and prices now anticipated. The fear is that the impact of the housing woes may push the broader economy into recession. In addition, with financial institutions under pressure from direct and indirect defaults arising from the subprime issue, lending standards will be tightened and credit availability is at risk, which would further impact growth.

"One of the issues which markets are grappling with is how the subprime crisis will unfold from here. Securitisation of debt has spread credit risk more widely amongst investors than has been the case historically and it is unclear, as yet, how this will feed its way through credit markets. Most are relatively sanguine on the risks of a broader credit crunch emanating from the subprime issues though nerves in markets are becoming stretched.

"For investors one must be mindful of time horizons in portfolios. Our view is that recession will likely be avoided in the US and, while credit conditions are deteriorating, a prolonged and significant credit crunch will not occur. Underlying fundamentals in the corporate sector and broad economy are supportive for financial assets and, notwithstanding, the omnipresent risks in the global backdrop the outlook for equity investments is sound. Our view is that we are experiencing a correction within the context of an ongoing bull market in equities.

Short term, however, volatility will remain extremely high, in our view, with significant risks of another downleg in equity markets as investors continue to fret over the spillover effects of US credit issues. Previous bull market corrections such as the sell off markets experienced in May of last year, tend to be characterised by a secondary downturn and panic selling before a trough is reached – something which we have not seen yet - and it would be foolish to dismiss the risk of history repeating itself. Nevertheless, the fundamental backdrop remains supportive and, in the absence of fundamental change, we continue to view further material weakness as a buying opportunity."