The business cycle goes on

2008 is a year that most investors would prefer to forget. I should confess up front that I didn’t see anywhere near the severity or the duration of the panic we have seen. So what went wrong?

As in 2007, the past year has been dominated by the US housing slump and the resulting fallout for investors who were exposed to it and the flow-on to real economic activity. But unlike in 2007, it morphed into the worst financial crisis since the Great Depression.

During the first half of the year, there was a perception the fallout from the sub-prime mortgage crisis was manageable and that the world would get by with ‘just’ a severe slowdown ahead of recovery in 2009. In fact, during the first half of the year, talk that China would remain strong saw commodity prices, notably oil and food stuffs, pushed to record highs.

However, things changed radically for the worst during the second half.

The catalyst was the decision by US authorities to let investment bank Lehman Brothers fail. This led to the failure or rescue of numerous financial institutions in the US and Europe. While the US authorities quickly rushed in with a bank rescue plan, in convincing Congress of the need to pass it they convinced the world of the severity of the problem.

The result was a massive slump in share markets, a renewed blowout in borrowing spreads in credit markets, a plunge in commodity prices and huge gyrations in currency markets. When the dust settled it was clear that all the turmoil had also caused immense damage to the global economy.

The slump in export demand and commodity prices also dragged emerging countries, including China, into the downturn.

Thanks to a synchronised recession, advanced countries are now on track for their worst post-war recession. Even the Australian economy has slowed sharply.

The end result has been a terrible year for investors.

From their highs last year, Australian shares have had their worst bear market since the 1973-74 slump; day-to-day share market volatility has been at levels not previously seen with the exception of October 1987; commodity prices have gone from boom to bust; the Australian dollar gave up five years of gains that took it to near parity in four months.

So what are the lessons of all this for investors? There are several. The business cycle is alive and well. Sentiment plays a massive role not just in share markets but in keeping the global economy motoring along.

Government bonds, which had long been relegated to ‘being boring’ have been the best performing asset class over the past year and clearly have a role to play as a diversifier for investors.

Hedge funds are not quite what they were cracked up to be after terrible performances over the past two months. Too much leverage is bad. There is good debt and bad debt — for example, margin debt. And the pendulum had probably swung too far in favour of deregulated financial markets.

Another lesson is that governments around the world have not forgotten the mistakes that led to the Great Depression and will do whatever is necessary to make sure it doesn’t happen again. Central banks pumping huge amounts of liquidity into financial markets, slashing interest rates and announcing huge fiscal stimulus packages.

History tells us that markets go up and down. Certainly the downswing over the past year has been among the worst.

But history also tells us there are great opportunities for investors when fear is running rampant and confidence is blown, when shares are trading on dividend yields well above bond and cash yields, as is currently the case, and when governments are doing everything possible to bring about an eventual economic recovery.

Shane Oliver is the head of Investment Strategy and is chief economist at AMP Capital Investors.