Weekly outlook

And where were you in 2008?
 
By Tom Stevenson, 24 December 2008

A handful of years attain iconic status – 1914, 1929, 1968 – 2008 is likely to join them  It was a year in which we almost ran out of superlatives. The past 12 months brought us the first black president of the USA, the most spectacular and expensive Olympic Games and the worst financial crisis since the Great Depression. A few years become associated with one event – who cares what else happened in 1929? – and 2008 looks poised to become one of these iconic dates, the year of the credit crash. First and foremost for visitors to this website, 2008 was a grim year for investors. The carnage was not across the board – government bonds, as the green line on the chart below shows, ended the year higher than they began after a string of aggressive rate cuts and gold held its own – but it was not easy to avoid heavy losses.

"The best that can be said of 2008 from an investor’s perspective is that the markets have fulfilled their established function of discounting the future" Tom Stevenson

With only a few trading days remaining, the FTSE 100 has fallen 34% this year, America’s S&P500 is 41% down year to date, and the Nikkei fell 43%. Some of the previously high-flying emerging markets fared even worse as investors abandoned the belief that the developing world could shrug off the economic difficulties triggered by America’s sub-prime crisis.



Although the financial crisis had begun in 2007 (the first, largely ignored straws in the wind were as early as March 2007 when HSBC warned of losses at its Household subsidiary), it really got into its stride in 2008. The collapse of Bear Stearns in March 2008 seemed at the time to be a pivotal moment, but it merely foreshadowed the year’s most significant financial event, the implosion of Lehman Brothers in September.

Allowing the 158-year old US investment bank to go down shattered the financial world’s confidence. Lending seized as banks lost faith in the credit-worthiness of their counterparties, with devastating and still unfolding consequences in the “real” economy.

The near collapse of the US auto industry is the most tangible sign that what happened in 2007/8 was more than just another financial boom and bust. More parochially, the failure of High Street fixture Woolworths marks the end of an era, with more retail collapses predicted once Christmas is out of the way.

The scale of the leverage underpinning the global financial system and its extreme complexity meant that the whole machinery of trade and finance came closer to complete failure than ever before this year. For a few scary days in October, the world looked into the financial abyss.

We stepped back thanks to unprecedented action by the world’s central banks and policy-makers. All the levers of monetary and fiscal policy have been applied with new-found force and unimaginable sums have been thrown at the problem. No-one knows what the long-run impact of these measures will be.

Some things happened this year that would have seemed scarcely credible in January.

Shares began to offer investors a higher income yield than risk-free government bonds for the first time since 1958. Today the yield on the FTSE100 is 4.6% while that on the benchmark 10-year gilt is just 3.1%. Fifty years ago marked the beginning of the so-called “cult of the equity” in which long-term investors turned to shares as a hedge against inflation. They accepted a lower initial yield on stocks because they expected share dividends to grow. Today investors’ main pre-occupation is with income rather than capital growth, which in itself is a reversion to form – over many years, the re-investment of income has provided the lion’s share of the total return from equities.

The yield cross-over this year also reflects a flight to safety, as investors have valued the fixed-income and government guarantee implied by a gilt or treasury bond. This has led to a second extraordinary event this year – the first time since 1941 that a US Treasury bill has been sold with a negative yield. Nervous investors have literally been prepared to pay for the safety of Uncle Sam’s backing.

The third amazing event in 2008 has been the dramatic swing in the financial world’s principal fear from inflation to deflation. This is illustrated most clearly by an extraordinary reversal in the oil price in the middle of the year. Having spent the first six months rising in a more or less straight line to a peak of more than $140 a barrel, with many respected forecasters pencilling in $200 as the next stop, the price of Brent crude has tumbled just as quickly to less than $40 a barrel.



The speed of the rise and fall of the oil price has been dramatic, although the oil market, dependent on the ups and downs of global economic demand, is at least used to this kind of roller-coaster ride. Even more striking, viewed from the perspective of the UK, has been the way in which the value of the pound has fallen off a cliff since the summer.



The decline in the value of sterling this year reflects both its initial over-valuation against the dollar and the euro (the chart looks very similar!) and the concern that Britain’s high levels of personal and public sector debts and its relatively large financial sector make it uniquely exposed to the cold winds of the post-credit crunch downturn.

The best that can be said of 2008 from an investor’s perspective is that the markets have fulfilled their established function of discounting the future. Everyone now expects 2009 to be a dreadful year in the real economy, with unemployment rising, corporate failures mounting and house prices continuing to fall. But Mr Market already knows this. He may have been a bit slow to cotton on to the likely impact of the credit crunch in the real world, but once the penny dropped he moved quickly to factor in the bad news to come.

It is possible that things turn out even worse than feared in 2009 but investors are starting to shrug off bad news and that is a sign that things are now in the price. Next week, I will look forward to what 2009 might bring but it would be surprising if 2008 was not as bad as it gets for investors.

On that hopeful note, may I wish you all a very happy Christmas.