A Boost For Belief In Banks

Posted on: 22 April 2008 by Gareth Hargreaves

Graham Kerner dissects the week's financial and economic news.


Markets have been boosted by the belief that banks are now serious about re-building their capital base.

The state of the property market and its potential adverse impact on the consumer are under scrutiny following evidence of weak lending last month.

Suggestions for tax-planning include Investment Bonds, specifically Offshore Bonds, and the ability to switch cash ISAs into stock and shares - for those looking for income equity dividends are looking attractive.

Right Said Fred

Financial markets got off to a wobbly start last week as Philips, the Dutch electrical conglomerate, provided a down beat start to the European earnings season by announcing a drop in first quarter profits. The news, which came hard on the heels of General Electric's shock announcement the previous week, was seen as the latest indicator of an economic slowdown and unsurprisingly sent European bourses lower. Investors remained cautious, watching for further signs of the impact of the credit crunch on corporate profits, but took a fairly sanguine view of unexpectedly robust US inflation figures, according to The Financial Times, even though oil prices hit another new high of $116 per barrel.

In contrast, UK consumer price inflation came in lower than expected, suggesting retailers are finding it difficult to pass on higher costs. The data co-incided with a survey by the Royal Institution of Chartered Surveyors pointing to a deepening slowdown in the housing market and, partially as a consequence, sterling fell in the belief the Bank of England may have more scope to cut interest rates.

However it was news from the beleaguered banking sector that really provided a fillip for the UK stock market, with Royal Bank of Scotland (RBS) announcing that it is planning a major rights issue to raise capital to restore its balance sheet in the wake of another £4 to 5 billion of write downs related to the sub-prime crisis. Whilst the weekend press speculated on the size of the cash call - anything from £10 to 12 billion according to The Sunday Times - it became clear that the future of the bank's CEO, Sir Fred Goodwin, is in the balance, according to the paper. The Telegraph speculated that rivals might also seize the chance to follow suit, with political pressure for the banks to strengthen their finances possibly tipping the scales. There are rumours that the Government is planning a massive £50 billion of liquidity in an attempt to ease the banks' problems.

Of course, it is not just the UK's banks that are suffering. The Independent reported that investment bank Merrill Lynch had told shareholders and employees that there was more pain to come in the form of another $9.7 billion of write downs and 4,000 job losses. Its Wall Street rival Citigroup too underlined the plight of financial firms squeezed by the credit crunch and the slowing of the US economy by announcing its own $5.1 billion loss and nearly $16 billion in write downs, together with 9,000 job cuts.

However whilst the news was bad, the announcements from the banking sector were well received by investors, who saw it as a positive step that at long last banks are beginning to face up to their problems and to stop being in denial. The Daily Telegraph quoted a major shareholder in RBS as saying, "All of them agree that the industry as a whole needs to be better capitalised, but none believes the observation applies to them individually."

So, by the end of the week, equity and credit investors gave a loud cheer for the banking sector, with The Financial Times saying that analysts believed that the worst is over and banks can weather the credit storm. In response, European and US equity markets made solid gains, with London up over 2 per cent and Wall Street advancing over 500 points to close at 12,849. Away from the equity markets, trading in currencies was volatile with the Yen sinking, the euro hitting a record high against both sterling and the US dollar before retreating.

Home Sweet Home

The UK's obsession with property over recent years means that the effect of the credit crunch is having a real impact on the sector and captures the headlines, as it did once more last week.

The Times said that the start of the home buying season was a damp squib this year, as potential buyers grappled with sharp rises in mortgage rates. Lending was down some 17 per cent in March compared to a year earlier, according to figures from the Council of Mortgage Lenders, but better than February's. The CML also took the opportunity to warn that lenders would not be able to continue to offer mortgages at reasonable rates unless the Bank of England stepped up its efforts to ease liquidity strains. Economists joined-in, saying a continued mortgage drought would exacerbate the fall in house prices.

The Financial Times pointed out to its readers that the buy-to let craze has turned sour for some, with new build flats, the type typically bought by buy-to-let investors, accounting for 45 per cent of the repossessed properties sold at auction.

The Sunday Telegraph joined in too by asking if the housing indices actually stack up following mixed numbers from the likes of Nationwide, Halifax and the Land Registry. The paper pointed out that in December the Nationwide index fell 0.4 per cent whilst the Halifax's rose 1.4 per cent, although both indices confirm price falls this year.

In true form, the City offers investors the opportunity to bet on the price of house prices via the use of derivatives, which is pricing in a fall of between 10 and 12 per cent over the next two years.

If you find this all too depressing then perhaps head south to the sunshine. The problem is that for the tens of thousands of Britons who have done just that and bought second homes in mainland Europe, a falling pound has made life more expensive. The Financial Times observed that with sterling trading at around 80p per euro - compared to 66p over a year ago - foreign currency mortgages are now costing more and for good measure property prices in the likes of Spain have slumped.

But as economist David Miles said in The Sunday Times, lower house prices do not consistently lead to lower GDP and the UK economy is continuing to grow despite the sector's travails.

Too Taxing

With the Chancellor having made numerous changes to the UK's multi-faceted tax regime in his latest Budget, The Sunday Times thought now was a good opportunity to review one's options and see how we can all cut a potential tax bill.

One of the paper's ideas involved using investment bonds - both onshore and offshore are available, but the latter was highlighted. Investors can take advantage of an added tax perk by withdrawing up to 5 per cent of the original investment into the bond, to then use as income with no tax to pay until the entire bond is cashed. Returns are likely to be higher because they effectively grow tax-free the paper said, adding that for investors who expect to move from a higher tax band to a lower one or plan to retire abroad a bond can be beneficial. The paper also pointed that clever use of bonds in conjunction with pension planning - where investors are in drawdown for example - can potentially significantly reduce their tax bill.

The Financial Times drew its readers' attention to the fact that investors can now switch their cash Individual Savings Accounts (ISAs) into their equity or stocks and shares ISAs. Whilst there is extra risk by moving from cash to equities, the paper said that it might be appropriate where an investor's risk profile has changed or they have simply built up a larger store of cash than they really need.

Many investors like the idea of tax-free income that an ISA can provide and the paper highlighted the fact that dividends from equities are looking healthy at present, even though the stock-market has been volatile of late. Dividend yields from many companies are close to the income yields from gilts and historically dividends have grown faster than inflation so preserving the real value. At present, one in four companies in the FTSE100 index yield more than a ten-year gilt and some sectors yield over 5 per cent - and remember that dividends are paid net of any basic rate tax liability. Of course the ability of a company to pay is important, but even here the ratio of dividend cover - the number of times a dividend can be paid from earnings - is high amongst quality companies. The best way to access this type of strategy would be through an equity income fund held within an ISA.

Buy Cheap, Sell High

An obvious investment objective, but not necessarily as easy to achieve as many investors will know. However it is possible, as Mark Evans, partner with THS Partners, points out, providing one is patient.

"I suppose we are the proverbial tortoise of the investment world: conservative, but also prepared to capitalise on opportunity. We are long-term investors not traders and prefer not to follow the herd because we are unimpressed by investment fashions. Clearly there are problems today caused by cheap money stoking an asset bubble and leaving markets over-geared.

"The credit crunch is serious, but it's not the end of the world and, with banks having written off some $200 billion in bad debt we are solving the problem. The likes of RBS are actively seeking to re-build their capital base and we do actually own the stock, although we have generally avoided the rest of the UK banking sector. HSBC is a truly global bank, is well capitalised and we think they will succeed in the current difficult environment by increasing market share and buying up mortgage securities at very low prices.

"The US economy is slowing, but some of the slack will be taken up by the emerging economies and the current environment is a good background for the type of multi-national we own. Being attracted to unfashionable areas has led us to buy continental European financials with some of the liquidity we built up early last year, which meant we went into the crisis with a large cash cushion. Financials are offering good value and we are looking at the property sector, where many companies are trading on half their net asset value.

"We continue to develop our thematic approach - the clean energy theme was started about three years ago, so today we own EDF, a French nuclear power generator and followed up with other companies that will benefit from the desire to use less energy. For example, carbon fibre is used in planes for weight reduction and Mitsubishi is the technology leader in this field.

"So now is a good time for us as managers, valuations are cheap and there are lots of companies to buy: it's just how quickly we do this. Being patient does bring its rewards and again as an example, if one invested 10 years ago in the MSCI World Index you'd be up 30 per cent. In contrast, the St. James's Place International Trust, which we have managed since 1971, is up 92 per cent over the same period."

21st April 2008

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