With the global equity bull market having run for four years, financial analysts started this year with a fairly pessimistic outlook. Warnings that investors should not expect the strong annual financial growth to continue abounded. But, as the year draws to an end, our local equity market has grown returns of more than 20%, global emerging markets more than 40% and developed markets just more than 10% — healthy returns, proving the gloomy expectations for 2007 wrong.
The other sector that financial forecasters were cautious about was commodities. With commodities having already run steeply on the back of unprecedented demand from the emerging and developing world, a softening in commodity prices was expected. Furthermore, with the looming United States housing sector fallout, talk of a recession in that country and with US consumption growth expected to slow, economic growth in the emerging world was expected to suffer. However, the bulls won this debate too: this year an investment in precious metals prices returned about 25% and oil more than 50%. During the year emerging market economies continued to grow in high single digits with China’s GDP in steady double-digits, providing the impetus for commodity markets.
Emerging economies began to “decouple” their growth path from that of the developed world — this was a new and unexpected phenomenon. Through the market fallouts of August and November this year, the fall in emerging market equities was shallower and the bounce back stronger than that of the developed economies. Emerging equity markets managed to hold their own on the back of solid economic fundamentals, large financial reserves, internal consumption growth and infrastructural development. These economies, which have always been dependent on the US consumer for growth, were supported by strong consumer consumption and infrastructure growth in their own countries and, therefore, suffered limited negative contagion this year, while the US and other developed economies swayed under their housing and credit crises. In fact, there is a reverse dependence developing with foreign earnings now supporting US firms as their domestic economy cools.
The long-held expectations for a downturn in the US housing market finally came to pass, but what caught market players, central banks and governments by surprise was the extent of the damage it caused to global corporate credit markets. Because US housing prices had grown so strongly for so long, US consumers were allowed to take on bigger and bigger home loans with lenders happy that the houses underlying the loans would simply continue to rise in value. The 4,25% in interest rate hikes by the US Federal Reserve Bank from mid-2004 to mid-2006, which effectively raised the cost of money and thus the access to credit, finally began to bite and mortgage defaults started to rise.
Home sales plummeted and the financial institutions that had provided the loans began to fold. The larger investment and commercial banks that had underwritten and invested in many of these loans also suffered significant losses, prompting the Federal Reserve Bank to kick off the global interest rate easing the cycle in October this year.
As we approach 2008, concerns linger about the health of the US — and by implication — the global financial system and whether global central banks will manage to avert the credit crisis by decreasing the cost of credit. In the second half of this year much of the financial market volatility came from the obvious need for lower interest rates to support the slowing US economy and ease the credit crunch, but resilient inflationary pressures prevented the central bank from embarking on any aggressive action.
Although still significantly lower than it was a decade ago, central bank complacency about inflation has been shaken up. With food and fuel prices at record highs, central banks are reluctant to ease, but at the same time are aware that economic growth is already slowing. It is this dilemma that forms the central question financial analysts are grappling with as we enter next year: which risk is larger — the upside risk to inflation or the downside risk of economic growth, and what will the world’s central bankers do about it?