LONDON (Reuters) –
If markets are forward looking, investors might find themselves tempted to buy stocks and other risky assets just as major economies, most of them already in recession, deteriorate further.
The euro zone, Japan, Singapore and Sweden are already confirmed in recession and the United States, Britain and other countries are half way into recession as the credit crunch since August 2007 bites into consumption and corporate profits.
However, markets and real economies are not synchronized.
According to Barclays, in the early 1990s, when Sweden struggled with its banking crisis, the stock market rallied the month after the government intervened in banks, while the economy worsened and was in recession for another three quarters.
Credit Suisse estimates that equities reach a bottom up to five quarters before the trough in earnings and three months before troughs in earnings momentum -- which currently is close to an all-time low in Europe.
World stocks, measured by MSCI, have risen every single day after hitting a 5-1/2 year low on November 21, helped by a round of interest rate cuts and fiscal stimulus packages worldwide.
"Generally speaking, markets have a pretty good track record of seeing the end of recession before the real economy started picking up," said Rob Hepworth, senior fund manager at insurance firm Ecclesiastical.
"They are forward looking but they don't always get it right... My yardsticks would be that things get so bad, news seems so bad and it doesn't make stock prices go down. For me, then, all the bad news is in price." Hepworth said an example of this could be found in the triple-B corporate bond market, where spreads have blown out to 700 basis points above UK government bonds to yield around 11 percent, compared with historical spreads of around 50-80 bps. "It's assuming an absolute Armageddon - one in every 15 companies go bust with no recovery. Even with this, you are still better off buying triple-B bonds than gilts," Hepworth said, adding that bond holders typically recover 40 percent of money in the event that a company goes bankrupt.
This week's data could add to the gloom on the economic front. Friday's data is expected to show the U.S. economy has lost another 300,000 non-farm payroll jobs in November.
Both the European Central Bank and Bank of England are set to lower the cost of borrowing again on Thursday, which could make the climate more friendly for risk seeking investors.
BUYING IN RECOVERIES
Barclays analysis on U.S. assets since 1929 shows that equities, bonds, Treasury bills gave the highest yearly real returns of 14 percent, 9.3 percent and 2.9 percent respectively when growth and inflation was low.
The second best return across three assets was achieved when growth was high and inflation was low, at 10.6 percent, 5.2 percent and 1.3 percent respectively.
Credit Suisse's analysis going back to the 1870s shows that on the eight occasions equities have fallen by more than 20 percent in a calendar year, six of the following years have produced positive returns -- but some of the rise proves to be a bear market rally.
"In downturns, the earnings multiples of cyclical stocks, after initially falling steeply, have a tendency, once the downgrades cycle is past and the earnings outlook stabilizes, to then expand," said Raj Shant, director at investment management firm Newton.
He said European stocks are trading on an underlying multiple for 2009 of 13 to 14 times earnings, assuming a severe earnings recession next year.
"So the time to buy in recoveries can be when multiples look high, and by the middle of 2009 multiples on some European cyclicals could look very high," he said.
INFLATION... WILL BE BACK?
A mix of a slowing economy and an eventual recovery points to higher inflation in the medium to long term.
Inflation-linked bonds offer protection against inflation as payments to investors adjust automatically to compensate for rising prices. Even when inflation is low, these bonds give stable real returns.
For UK index-linked bonds maturing in 2030, the real yield would be 1.7 percent if inflation stood at 1-3 percent, according to AXA Investment Managers.
With inflation of 10 percent, real yields would dip only to 1.5 percent.
The redemption price would be 301.3 when inflation is 3 percent, compared with 231.318 currently.
"I don't want to predict an economic disaster but every time there is one there is buoyancy in inflation-linked bonds," said Jim Stride, managing director and head of UK equities at AXA.
Performance data of UK inflation-linked bonds while the economy had deflation is scarce. However, Stride said: "Investors might be pleasantly surprised by what would happen to linkers in a period of genuine deflation."
(Editing by Anthony Barker)