Markets

History lessons

Investors will be watching politics as well as price-earnings ratios next year

IF HISTORY is any guide, 2008 should be a better-than-average year for America’s stockmarkets. Figures culled from the Barclays Equity-Gilt Study show that since 1926 Wall Street has risen by an average of 8.8% in presidential-election years, perhaps because politicians pull out all the stops to ensure they get elected.

However, although such statistics may be superficially appealing, this could easily be a random effect. After all, 1932 was an election year and it saw the absolute market nadir after the crash of 1929. The markets also fell in 1940, 1948, 1960, 1984 and 2000. In down years for the stockmarket the incumbent party was just as likely to be re-elected as thrown from office.

If politics has any effect in 2008 it may be to make investors a little nervous. This will be the first presidential election since 1952 in which neither a sitting president nor vice-president is running for office. That will create a climate of uncertainty, which markets traditionally dislike. And, to the extent that either party is the favourite, it will be the Democrats, whereas Wall Street favours the Republicans.

The election aside, perhaps the key question for markets is whether the profitability of the corporate sector can be sustained. In America, profits are running at around a 40-year high as a proportion of GDP. Some people, such as Andrew Smithers, an independent strategist, argue that they are doomed to return to the mean. But others argue that profits can be sustained because of the effects of globalisation: the emergence of China and India has shifted the balance of power in favour of capital and against labour.

The question is important because of the measure that investors rely on to assess market valuations: the price-earnings ratio. Optimists argue that, on the basis of forecast profits, shares look cheap by historical standards. But the pessimists say this is because profits are cyclically high; use a smoothed average of profits and valuations are as high as they were before the crash of 1929.

American corporate profits may come under pressure if, as expected, the economy slows under the influence of the turmoil in the housing market. And equities may also lose one source of support if the credit crunch that started in the summer of 2007 lessens the ability of private-equity groups to launch takeovers and also makes it harder for companies to buy back their own shares.

However, as the year rolls on investors may start looking to an economic rebound in 2009, especially if the Federal Reserve continues the cycle of interest-rate cuts that began in September 2007.

In foreign-exchange markets, the big issue will be the durability of the carry trade, which has seen speculators borrow in low-yielding currencies—notably the yen—to invest in higher-yielding currencies and assets. The carry trade has had several wobbles in recent years as investors have taken fright and left some of its more exotic beneficiaries, such as the Icelandic krona or the New Zealand dollar. The main pressure on the carry trade in 2008 will probably come from the combination of falling American interest rates and some modest increases in Japanese rates. The danger is that investors (including those Japanese who have pushed money overseas) will tire of losing money and cut their bets, causing a sharp jump in the yen. However, the good news is that a combination of a weaker dollar and slower American economic growth should reduce the American trade deficit, one of the main imbalances in the global economy.

In bond markets, the credit crunch of summer 2007 will continue to reverberate. Rating agencies are expecting an increase in the default rate on corporate bonds, if only because cash-strapped companies will find it more difficult to find finance. That will inevitably provide a further test for the complex structured products created in recent years, such as collateralised debt obligations (CDOS).

Investors will be looking to see whether the subprime effect is repeated in corporate debt; in other words, whether the repackaging of loans and bonds has led to a lowering of credit standards. That may well be the case, since the dash for yield in 2004-06 made it far easier for companies to raise funds on what, by historical standards, looked rather generous terms. What seems virtually certain is that there will be some scandals; as Warren Buffett has remarked, it’s only when the tide goes out that you find out who’s been swimming naked.

One sector that might get shipwrecked in 2008 is commercial property. Like residential property, it is vulnerable to higher borrowing costs and slower economic growth. Investors have dashed into property in recent years because of attractive yields; those yields no longer offer quite so much compensation for risk. Office property in London and New York might be adversely affected if credit problems prompt the financial industry to shed jobs.

Finally, investors will also be on the lookout for one of Nassim Taleb’s black swans (extreme, unpredictable events), although by definition these cannot be foreseen. A military strike against Iran is not really in the black-swan category, since it has already been widely discussed, but it is hard to believe that the prospect is priced into financial markets. The global economy has coped admirably with oil at $70 and even $80 a barrel; whether it could sustain $100 a barrel for very long (as might happen if supplies from the Gulf are interrupted) is another matter.