Grapes upon the vine?

The winner of the British TV talent show The X Factor, Alexandra Burke, is now the hot favourite to be No 1 in the UK pop charts this Christmas with a cover version of Leonard Cohen’s Hallelujah. The song has several clear references to the Old Testament, including Samuel and the Book of Judges, though none to the Nativity. However, the thought of a song by Cohen topping the charts during the coming (compulsory) seasonal jollity does have a certain delicious irony to it. Most of his work is famously dark.

Another song by Cohen, Diamonds in the Mine, offers a typically gloomy worldview: “And there are no letters in the mailbox, and there are no grapes upon the vine, and there are no chocolates in the boxes anymore, and there are no diamonds in the mine.” Unfortunately, Simon Cowell isn’t a reader so that choicely pessimistic tune will not be drifting over the airwaves in the coming weeks. However, as a soundtrack to the mood of markets it is far more fitting than Hallelujah.

Across asset classes it has truly been an annus horribilis. The only safe haven has been government bonds and only then if accompanied by some canny currency hedging. The 10% fall in the DXY (dollar) index in the past month is just the latest wild swing which is doubtless causing collateral damage to portfolios. Commodity investors at least enjoyed one last rotation of the super-cycle, the S&P GSCI Index rose 41% in the first half of the year. The wheels have since come off. The index is down 47% year-to-date. Peak-to-trough it has fallen at an annualized rate of 94%.

For investors in equity and credit, markets have been less of a rollercoaster. They have simply been grindingly miserable. The MSCI World Index of developed market equities has endured the worst year in its 38-year history. It has crammed into a little under 12-months a worse performance than 1973 and 1974 combined. You can be forgiven if you did not find the best performing market in the world (Tunisia) which still fell.

Credit markets went from really bad in 2007 to abject in 2008. The spreads of US ABS and CMBS indices are between three and five times wider than they ever have been. Plain vanilla corporate bonds are priced to suffer default rates last seen in the Great Depression. In the search for safety government bond yields in the US have been driven down to levels only seen in Japan when it was suffering chronic deflation.

A debt deflation bust across the developed world seems now to be the central economic outlook reflected by prices. Though only the seriously ill-informed make comparisons with the Great Depression, something akin to Japan’s lost decade would indeed weigh on risky assets (Chart 1). There are hints, however, that institutional investors are beginning to question the likelihood of this outcome.

Perhaps the most intriguing message from across the suite of investor behaviour indicators used by the strategy teams at State Street Global Markets is that institutional investors are no longer aggressively adding to their holdings of sovereign bonds (Chart 2). This is a step back from the extreme levels of risk aversion in the weeks immediately following the collapse of Lehman Brothers

Since that misfortune, policy coordination across the world’s central banks has been far more in evidence. The once hawkish European Central Bank has cut interest rates by 175bp from their July peak and money is cheaper in the UK than at any time since 1951. This policy re-coupling with the US Federal Reserve in the vanguard will continue next year. The G7 is heading into the zero bound.

It is also more than likely that other central banks will reach for the unconventional policy levers already being pulled in the US. We can expect massive fiscal stimulus, the printing of money to fund the outright purchases of risky assets and direct intermediation in credit markets. These are uncharted waters. Nobody can say with any degree of conviction whether they will work, let alone what this policy prescription will mean for the growth and inflation outlook in the medium to long term.

Against this backdrop of uncertainty the most sensible course of action may be to take some risk. The global economy is heading for a barren year in 2009. But the stock market will try to anticipate the recovery. There may well be false dawns, as was the case in Japan in the 1990s. But even if debt deflation does take hold, staying on the sidelines during what could be significant counter-trend rallies will be very detrimental to performance.

Gauging sentiment in what will likely be another volatile year will be crucial. For risk-seeking behaviour to become entrenched it would take a leap of faith, or clear signs the reflationary medicine is working. This is not an environment to be singing Hallelujah. But let’s end 2008 on a positive note. Perhaps those missing grapes have been harvested and pressed into fine wine to accompany seasonal feasting. We could all do with a glass that cheers this Christmas.

* This is the last note of 2008. Normal service resumes on 9 January.

Chart 1: The Nikkei in Japan’s deflationary bust

Source: State Street Global Markets

Chart 2: Investors trim government bond holdings

Source: State Street Global Markets