A Weary Patience

Jul 25 2008 | 2:57am ET

By Sebastien Pris-Horvitz -- Almost a year ago, two hedge funds managed by Bear Stearns collapsed.  At the time, no one could have reasonably anticipated the disappearance of the century-old investment bank several months later; only the most pessimistic of outlooks could have foreseen that we would be where we are today.

World stock markets are down by 30%, more than $5 billion in market capitalization has disappeared, the banking sector is still weighed down by the weakness of its balance sheets, advanced countries have mediocre growth prospects, with many economies suffering from the drop in property prices, and inflation is rising at its fastest rate in at least a decade after a violent oil shock.

In this context, it is quite understandable that people are more nervous than usual about any news which adds to a list of uncertainties that is already very long. The fears about the solvency of the American mortgage giants Fannie Mae and Freddie Mac, and the bankruptcy of IndyMac Bank, have shaken the markets over the last few days.

A Deteriorated Economic Climate

It is clear that the optimism sparked by good growth figures in the first quarter of 2008 has waned. It would not be pessimistic, but rather realistic, to forecast mediocre world growth for the year to come, particularly in the advanced economies. Growth in Europe and the U.S. is likely to be around 1% in 2009, a consequence of the adjustment caused by the financial crisis and the increase in the oil price.

The "good news" is that inflation should gradually go down, with a decline in commodity prices and increasing output gap. In the very short term, however, doubts will remain about the inflationary risk unless there is a rapid decline in the price of oil.

A Long Road Towards Financial Stability

Fannie Mae and Freddie Mac will not go bankrupt. The U.S. government cannot let these institutions fail, as they are behind nearly half of the American mortgage market, evaluated at $12 trillion (nearly 100% of gross domestic product). Thus, Congress will probably approve the new powers requested by the Treasury, including the power to bail out these private entities.

After Bear Stearns, this new public shield against the worsening of the financial crisis shows that the authorities are ready to act to stabilize the banking system. But it will still remain weak for some time. With IndyMac’s failure, five regional banks have gone bankrupt in 2008. More will have to be done to stabilize the U.S. banking system, starting with the mortgage market. Accordingly, in spite of inflationary fears, it is probable that, in Europe and in the U.S., monetary policy will remain relatively accommodating in order to avoid the worst.

Remain Sheltered For Now

Let's be clear: The road towards normalization of the markets will certainly be longer than usual, given the magnitude of the crises we are now coping with. On this road, the markets will tend to exaggerate and may anticipate the worst. We may be tempted to succumb to the Cassandra and give way to panic. Let's not forget, however, that the markets have already anticipated plenty of bad news, hence some very attractive valuations.

We continue to advise the prudent position that we have supported for eight months, by recommending that asset allocation should favor cash rather than risk assets. We know that, to get out of the rut, we need at least greater stability in the banking sector and a drop in the oil price (which will involve an economic slowdown, particularly in the emerging countries). The return of more favorable winds is not in doubt, supported by the ongoing globalization process. The constraints on natural resources, notably energy or the infrastructure challenges, will remain important investment themes.

Until then, we must continue to be wearily patient so that we can benefit from those winds tomorrow.

Sebastien Pris-Horvitz is the director of investment strategy at AXA Investment Management.

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