There is now clear evidence that the green shoots of economic recovery are withering in the summer sun.
Further proof that Britain’s economy is still in the doldrums came on Wednesday when the Organisation for Economic Co-operation and Development (OECD) forecast that the UK economy will contract by 4.3 per cent this year and said it expects only “modest growth” in 2010.
Meanwhile, across the Atlantic, it emerged that the US economy had contracted by more than 5 per cent in the first three months of the year.
Since the start of the month, the FTSE 100 is 5.4 per cent lower, the S&P 500 is down 2.4 per cent and the FTSE Emerging Markets index has lost 5.2 per cent.
“The setback is that the market needed a period of consolidation after a very good run,” says Ted Scott, a director with F&C fund managers. “The market was overbought in the previous three months as fund managers disposed of defensives and chased cyclicals.”
The recent round of selling suggests opinions about the state of the economy are more grounded than they were two months ago. As James Foster, head of fixed interest at Artemis, puts it: “The equity market was getting excited about economic recovery statistics, but when you looked for detail, there was no evidence of genuine growth.”
Other analysts are also rejecting suggestions of an economic recovery in favour of a pessimistic hypothesis that – in spite of the encouraging slowdown in the rate of economic decline – the recession will be long and sustained.
Neil Michael, director of investment strategies at London & Capital, believes that depressed markets will flatline until confidence grows, lending improves, and fears about the glut of government bond issues diminish.
“On a historical basis, confidence indices are well below normal levels,” he says. “Company defaults are still rising. Credit is still very tight. And industrial production rates in the UK and the US are at their lowest level since the second world war.”
“I think the green shoots will eventually flourish into very attractive plants, but the cold winds of reality may keep them stunted for some time. The markets have to pause for breath.”
Up for debate is the likely outperformance of emerging markets against developed ones – as more companies look to pay off debt in this period of deleveraging.
Julian Thompson, Threadneedle’s head of emerging market equities, predicts that both Brazil and China will withstand the lingering effects of the financial crisis better than developed countries, because of their well-capitalised banking systems.
The rate of domestic consumption recorded in Brazil jumped by 0.8 per cent in the first quarter from the same period a year ago, which is very encouraging, according to Thompson.
“If we see domestic consumption pick up in Brazil and other emerging markets, then investments will follow,” he says.
“As interest rates come down, banks will want to lend more to consumers, so you will see a pick-up in loan growth in emerging markets,” he adds.
“By contrast, banks in the more developed markets are likely to continue to struggle. We are going through a process of deleveraging in developed markets and banks have too little equity relative to their loans, so they are still reluctant to lend.”
Another looming problem is the oversupply of government bonds in the market.
This year, projected gross issuance by OECD governments will jump to almost $12,000bn of debt – up from $9,000bn two years ago.
Yields on government bonds are rising on concerns about the scale of this issuance.
Ten-year US Treasury and UK gilt yields are both close to 4 per cent, having started the year at 2.22 per cent and 3.01 per cent respectively, even though their central banks have engaged in quantitative easing programmes. Gilt yields and 10-year US Treasuries could approach 5-6 per cent in a “worst-case” scenario.
As Bill Gross, chief executive of Pimco, the US bond house, explained in his monthly note to investors: “With time, markets will worry about the longer-term cost of high and growing public sector borrowing requirements. Indeed, it is already starting to happen.”
But the fall in the market after a sustained rally is throwing up opportunities for investors to reconsider their strategies.
Fund managers are taking advantage of the share price falls to increase their “risk” exposure by buying “cheaper” blue chips – as well as commodities – and by increasing their investment-grade and high-yield bond holdings.
“Cyclical share prices have run ahead of themselves, but defensive ones have been left behind,” says Scott at F&C. “And a number of companies, such as Vodafone and Glaxo, are offering attractive dividend yields of 5 or 6 per cent,” he adds.
The key to playing the bond markets is to avoid debt issued by high-quality companies – such as BP – in favour of “slightly weaker” groups in defensive sectors such as tobacco or discounted bank issues, according to Foster at Artemis.
