A Mixed Week For The Markets

Posted on: 09 December 2008 by Gareth Hargreaves

Expert Graham Kerner takes a look at what's happening in finance, during a mixed week for the markets.

Last week got off to an inauspicious start following news that manufacturing around the world has slumped in recent weeks - enough to send investors scurrying for the short-term safe haven of government bonds.

The Times reported that American manufacturing activity is falling at its sharpest pace in 26 years, with a similar story emanating from Britain and the eurozone. In the UK, the all-important services sector, which accounts for two-thirds of the economy, is shrinking at its fastest pace since 1979 when Margaret Thatcher came to power.

The latest CIPS (Chartered Institute of Purchasing and Supply) index not only confirmed the deepening plight of business – from service providers to the leisure industry – but heightened worries that the recession may be more severe than that of the early nineties. The most acute declines were felt in financial services, transport and communications industries where the credit crunch is leading to aggressive cost and staff cuts.

Interest Rate Cuts

It was against this backdrop that central banks announced a wave of interest cuts on Thursday in an attempt to spark stalled economies across the world. In the UK the Bank of England cut rates by a further 1% to 2% - a level not seen since 1951. In the eurozone the European Central Bank cut the cost of borrowing by a record 0.75% which, although bold, left stock markets underwhelmed. Elsewhere, rates fell sharply in New Zealand, Indonesia and Sweden as the authorities took unprecedented action in an effort to avoid a lengthy economic downturn, although most central bankers recognise further cuts are likely to be necessary.

The speed of the downturn has also led the ECB to downgrade its growth and inflation forecasts sharply for the region. The central bank now sees the economy shrinking by 1% - radically down from its earlier projection of up to 1.8% growth next year. It wasn’t only the European bourses that were unimpressed – in London the likelihood of a rate cut had already been discounted by the markets, leaving traders to switch their attention back to the outlook for corporate earnings.

However, in the money markets the benchmark interbank lending rate fell to its lowest ever level in response to the BoE’s decision. The three-month sterling LIBOR – the London Interbank Offered Rate – dropped to 3.3775%. LIBOR is taken as an indication of trust between banks: the less they trust each other the higher the rate. So the large fall has been a positive sign and provided a much-needed boost in confidence to the markets, although LIBOR is still 1.38% above bank base, compared to the long-term average of 0.25%. However, experts do expect LIBOR to continue to fall looking ahead.

American Dream Dissipates

In what is becoming a familiar pattern, more job losses were announced last week by two of America’s top corporations – telecommunications firm AT&T and the conglomerate General Electric, seen as a bellweather for US industry. GE said its fourth quarter profits would be at the lower end of expectations and said the group was considering job cuts in its financial and industrial divisions. The Times observed that twenty thousand people are employed in the UK by GE, including 6,000 at GE Capital, which provides sub-prime finance to Britons.

News emerged too that US factory orders suffered their largest fall for eight years in October, underlining the severity of the downturn. But it was news on Friday that US job losses reached a 34-year low that capped the week.. Whilst the numbers were always going to be bad, news that 533,000 workers had been laid off surprised analysts and brought the total of jobs lost in the last six months to 1.5m. As The Financial Times reported, it was no surprise that, alongside these figures, home foreclosures rose to record highs and some 7% of mortgage loans were now in arrears.

The plight of the American economy is probably best encapsulated by the state of the US automobile industry. The pleas for help have grown louder in recent weeks as the ‘Detroit Three’ – General Motors, Ford and Chrysler – press Congress for an emergency bailout in the region of $30bn. The credit crunch has led to sharp falls in new car sales, not just in the US, but across the world. According to the motor industry’s association ACEA, sales have fallen sharply across the board, ranging from down 27% in Japan to falls of almost 50% in Spain.

In the UK, The Sunday Times reported that 4,500 jobs are on the line at one of the country’s largest car parts group, Wagoner which is in difficulty and there are worries over the outlook for Vauxhall, a subsidiary of GM.

With some 3m American jobs potentially at risk in the US if the big three are allowed to go under, the pressure on Washington to provide short-term funding is intense. Late on Friday rumours of a government-sponsored aid package for the troubled car firms gave a last minute boost to Wall Street enabling the Dow Jones share index to rally almost 7% from its intra-day low. Sure enough, news emerged over the weekend that lawmakers on Capitol Hill had agreed to a short-term bail out totalling around $15bn to prevent an imminent collapse of the ailing industry.

But in a stark warning to British industry, Lord Mandelson the business secretary said there is no “blank cheque” to rescue troubled firms here in the UK. He said that “We will not be supporting companies with flawed business plans and companies with no prospect of recovery”.

A Week In The Markets

Against the backdrop of poor economic and corporate news it was hardly surprising that global equity markets struggled to make headway, despite interest rate cuts and crashing oil prices – the latter tumbled to below $41 per barrel. Since July the price of a barrel of oil has fallen almost two-thirds from its record high of $147pb. The falling price of crude merely re-inforced investors’ expectations that the global downturn was going to get worse before it gets better. And that of course is the big question – how long before things improve?

Well, things may be about to start slowly improving according to US economist Irwin Stelzer, writing in The Sunday Times. Whilst it was not good news to have politicians replacing the markets through the, albeit necessary, intervention of policymakers in Washington, the outlook is not all gloomy. Stelzer pointed out that petrol prices have fallen $2 per gallon with every $1 drop adding around $140bn to consumers’ buying power. The Fed’s decision to purchase as much as $600bn in mortgage-backed securities has driven mortgage rates down and led to a spurt in refinancing applications for the financing of new home purchases.

Other credit markets should ease when the Fed begins to purchase $200bn in securities backed by student loans, car loans and credit-card debt. Longer term, Stelzer took the view that the outlook might just be brighter, but much depends on whether government involvement in what was the private sector proves to be permanent.

Christmas Bonus

The BoE’s decision to cut interest rates will, according to The Times, mean an early Christmas present for around 3.6m homeowners in the UK. Borrowers with tracker mortgages will make immediate savings and the paper said that the typical borrower has seen repayments fall by £375 per month since October. Along with cheaper petrol prices, many households will now find themselves with more spending power – something the Chancellor is hoping everyone is going to do to help avoid a deep recession.

What might be good news for one is not necessarily so for all. The corollary of cheaper mortgages is of course lower savings rates and, as The Financial Times noted, the latest rate cut will be a blow to savers who have seen rates fall sharply in recent weeks. The situation could be about to become worse too. The Times said that Lord Mandelson will put pressure on the UK’s banks to pass on in full the recent interest rate cut – Gordon Brown is said to be increasingly frustrated at the banks’ refusal to pass on cheaper borrowing costs for homeowners and businesses. If this happened, savings rates will be hit further.

Unsurprisingly investors, especially those in need of income, are looking around to see what choices they have to diversify their investments in the current environment. This point was discussed in The Sunday Telegraph which mulled over the choices, ranging from internet savings accounts, cash unit trusts, gilts and corporate bonds. All have their merits, but perhaps the most interesting or unusual opportunity, appears to be happening in the corporate bond market where the paper said “Many bond managers remain bullish that now is a good time to buy as prices have fallen, pushing up yields”.

Corporate bonds are IOUs issued by companies and historically have done better than cash. There is some risk – there is no certainty that the company issuing the bond will always be around, but currently the market has become so pessimistic that it is assuming extraordinarily high rates of default. This has pushed capital values down and yields up. The paper said that the last time there was such a pronounced difference between the yields on bonds and gilts was 1929. It is quite possible to invest in corporate bond funds that are yielding over 10% gross and when the economy improves there is also the prospect of capital growth too.

One other area investors may consider putting money into are equities, where dividend yields – the FTSE100 yields c.5% net of tax - now exceed those on gilts, an infrequent occurrence and reflects the sharp falls in share prices in recent months. It is the latter point that is understandably making people wary about buying shares: and that’s the risk. Robert Smithson of THS Partners who manage funds for St. James’s Place thinks equities offer good long-term value at current levels.

“In recent weeks we have been using some of the liquidity within the portfolios to buy good quality companies which we believe will do well in the long term. With prices so depressed it is possible to buy stocks on very low earnings multiples and whilst the immediate outlook remains uncertain, we are confident that these businesses will continue to grow. We are not expecting stocks to rush ahead in the short term, but do believe that as an asset class, equities will offer good long- term value to investors”.

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