Bumpy ride in prospect for divided markets

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Every Christmas, investment bankers become embroiled in a vicious battle. For about now, each year, banks decide how to allocate their bonus pools – thus triggering fights about which parts of the market have boomed in the past year and which will grow next.

This year, however, the bonus battle could become unusually complex. For as 2007 turns into 2008, a sense of a divided thinking is dogging the financial world.

On the one hand, large swathes of the debt world are beset with a mood of near-apocalyptic gloom. For while early 2007 produced record levels of activity, this summer’s credit crunch shook the debt world to its core. And with the outlook for the US real estate sector remaining grim, most credit players expect activity to remain downbeat in 2008 – particularly in the structured finance sector. “A visitor from Mars might wonder what happened to that wall of liquidity from investors which suddenly morphed into a monumental credit squeeze,” says Stephen Davis, a banking consultant in London.

However, in the equity market world, the mood remains more upbeat. For while leading stock markets have slipped back from their early summer highs, this decline has been modest for Western indices.

Meanwhile, sentiment in the emerging market sector remains extremely cheery – not least because analysts expect regions such as emerging Asia to continue to expand strongly in 2008, as a tidal wave of liquidity swills around the region and the Gulf. “The world’s largest creditors continue to amass huge surpluses,” says Larry Kantor, analyst at Barclays Capital, which estimates that the current account surpluses of the largest seven creditors will reach $1,000bn this year.

This divided world presents investors with some extraordinarily difficult challenges. If the credit markets offer an accurate guide to the outlook, equity markets are now heading for a correction; however, if the equity markets are a better litmus test for next year’s trends, parts of the debt market now seem oversold.

Either way, “this is a tough time to be making asset allocation decisions,” points out David Brown, chief European economist at Bear Stearns. Or as Jack Malvey of Lehman Brothers notes: “In December 2007, the annual outlook fog is the thickest since December 1997 and December 2001.”

Nevertheless, amid this uncertainty, bankers outline three possible market scenarios for next year. One is the so-called apocalyptic path – or the idea that the current credit gloom spreads to infect the equity world.

For what has made the debt problems so pernicious this year – or so the pessimists argue – is not simply that the subprime losses are large, and spreading to other consumer areas, such as credit cards. Worse still, the subprime episode has shattered investor faith in the securitisation that enabled the debt world to expand so fast in recent years.

This means that in 2008 banks may face an upheaval in the way they do business – at the same time that they are being forced to write off credit losses. At best, this will force the banks to cut lending. “Surveys show that US banks are planning to tighten the amount and terms of their lending, to commercial and industrial borrowers as well as to households,” says Andrew Smithers, an independent economist.

But at worst, these credit pressures could tip the US economy into a recession, some observers fear, and spark a second phase of the credit crisis. For if growth slows sharply, that will spark corporate defaults, which, in turn will deliver a new wave of credit losses and almost certainly drag the equity market lower too.

However, most economists do not actually expect this apocalyptic scenario to play out. One reason is that the US still appears to be relatively resilient. “US activity data – especially jobs and car sales – suggest a weakening in growth and not a recession,” says Jan Loeys of JPMorgan.

Another point of optimism is that emerging markets continue to boom.

A third source of comfort is that there are signs that parts of the debt world are starting to adjust to the 2007 mortgage default shock – particularly given that policy makers are injecting liquidity into the money markets. “Investors will become optimistic again [in 2008] once they broadly understand the extent of the credit crisis and once they have confidence that a rescue, or the cavalry are on the way,” says Mr Loeys.

Indeed, some observers now think that far from delivering an apocalypse, 2008 could actually be the year when the markets start to recover – or when the credit sector starts to rally in line with equities.

But there is a third potential scenario: namely, that the current mood of market schizophrenia lingers on. For while the policy makers are now eager to boost market sentiment, their freedom to act is constrained by rising inflation. Similarly, while the investment banks tackle the subprime woes, they now risk being hit by problems arising from new areas – such as monolines.

“More likely [we will see], the ‘muddle through’ path which will alternate between periods of near-miss optimism and bulls-eye pessimism,” concludes Lehman Brothers. Stand by for a bumpy ride.

This article is the first in a series that consider the prospects for markets in 2008

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