Banking Sector Losses Worry Investors

Posted on: 19 January 2009 by Gareth Hargreaves

Graham Kerner gives his expert opinion on the current state of the world’s markets.

Global financial markets endured a testing time last week with the now almost routine flow of poor economic and corporate news fast becoming the norm for traders and investors.

It wasn’t just the news that US retail sales fell by more than expected – 2.7% in December – or even that the Federal Reserve’s Beige Book report said that manufacturing activity, labour market conditions and property prices had deteriorated further that really upset the markets.

Once again it was renewed fears over the health of the banking sector that perturbed investors last week, with the catalyst being news that Deutsche Bank made its first loss in 50 years after losing €4.8bn in the final quarter of last year. It also highlighted the fact that the bank might need to raise fresh capital, although Deutsche said it did not need to raise more equity to maintain its tier one capital ratio – an accepted measure of balance sheet strength.

Sentiment was also damaged following a forecast from Morgan Stanley that banking giant HSBC would cut its dividend and take a further write-down on its toxic assets of anything up to £37bn – quickly denied by the company.

As the week wore on more news from the banking sector merely exacerbated concerns that a new infusion of taxpayers’ cash would be needed to stem the problem. As The Financial Times reported, Citigroup not only announced an $8.29bn loss for the last quarter, but also that it was planning to break itself into two businesses – banking and broking, including asset management.

The news was closely followed by an announcement that Anglo Irish bank was to be nationalised by the Irish government in order to stabilise the sector. The final piece of news was reported by The Daily Telegraph – heavy losses by the Bank of America (BoA) following its decision to subsume Merrill Lynch last year also created some consternation. BoA posted a loss of $2.9bn for the final quarter of 2008, but this excluded a surprisingly large loss of $15.31bn from Merrill Lynch.

Absorbing the bank has proved far more expensive than originally envisaged and quickly led to an announcement by the US Treasury that BoA was to receive a fresh $20bn capital injection plus a guarantee from the Federal Reserve offering a back-stop to the losses on $118bn of Merrill’s most toxic assets. The news helped assuage some investors’ fears and dissipated the somewhat febrile atmosphere that had prevailed – the Vix Index (described as Wall Street’s fear index) ended the week at 48 - its lowest level for some time and well below the 86 seen during last September.

Of course globalisation means that events in the banking sector impact on all the major trading centres and so it was no surprise that, in London too, investors started fretting about the potentially large losses that might hit some of the UK banks if they were forced into writing down more losses: toxic or otherwise. In response, traders took the red pen to the banks’ share prices, with RBS leading the way, although the spotlight turned on Barclays in the last hour of trading on Friday when its shares fell 25% - forcing the company to make an after hours announcement that its forthcoming figures would surprise the market on the upside.

Against this backdrop the weekend press was full of rumour about the impending announcement of another rescue package by the UK government, with Gordon Brown and the Chancellor set to pull no punches with the banks this time round, according to The Sunday Telegraph. The paper speculated that the new package would be the most far reaching yet and that there would be no negotiation with the banks this time.

The Sunday Times said the banks were set to receive a £100bn lifeline and as a result take the government’s stake in RBS up to 70%, although the new Lloyds Banking Group was said to be resisting the attempts which would see an increase in government ownership over and above the current 47%.

The new proposals were thought to involve government guarantees for the issue of new consumer loans and mortgages, as well as effectively ring-fencing some of the banks’ toxic assets. And indeed the government did announce a package of support for the banks totalling £90bn this morning, confirming also that its stake in RBS would rise to 70% thus completing its race against time to stabilise the sector and help the economy.

China’s Bull Run

It was of course only a matter of time, but The Financial Times reported last week that, according to China’s National Bureau of Statistics the country overtook Germany to become the world’s third largest economy in 2007, following growth of 13% - higher than the 11.9% growth rate previously stated.

Growth in 2008 has been estimated around 9%, but many economists believe growth in 2009 will fall short of the 8% government forecast. Either way, the economy continues to grow apace and Goldman Sachs is forecasting that the Chinese economy will overtake that of the US by 2040. Not only did China’s GDP overtake Germany’s ($3.38trillion versus $3.3) but the country is also likely to surpass Germany as the world’s largest exporter following the global downturn which has hit German exporters hard.

Indeed the eurozone as a whole has stumbled, with data last week showing the region’s exports falling 5% in November and with the scale of the recession becoming clear only in recent days, it was no surprise that the European Central Bank announced a further half-point interest rate cut to 2%. In response the euro gave some ground, enabling it to end the week at 1.12 against sterling – well above the all-time low of 1.02 seen just a few weeks ago.

Food For Thought

The flow of poor economic news continued in Britain last week with innumerable headlines announcing job losses across the private sector. But it wasn’t all bad news.

True, the merger of BoA and Merrill Lynch will see 1,900 jobs cut – the equivalent of 30% of the London workforce, according to The Times. Barclays announced cuts of 2,100, pharmaceutical group Pfizer cut 240 and Jaguar Land Rover another 450. In total The Times said more than 8,000 jobs were lost during the week.

In contrast, however, BAE Systems intends to add 8,000 jobs in the UK and US this year with the company boosted by the security of state orders. But it was the food retailers that led the way with Tesco, Morrison’s, Waitrose, J Sainsbury and Aldi collectively announcing the creation of over 20,000 new jobs over the coming months.

Whilst the retailers have found it tough they have still managed to grow their businesses as consumers change their discretionary spending habits – eating and drinking more at home rather than going out to eat.

Investing For Income

As The Financial Times pointed out to its readers, banks are generating larger profit margins by refusing to pass on record cuts in interest rates to new mortgage borrowers whilst at the same time hitting savers hard by reducing rates by more than the reduction in the Bank rate.

Apparently the average interest rate on instant access accounts is 0.81% and on fixed-rate bond deposits down to 3.01%. Whilst cash is undoubtedly losing some of its allure, the issue for savers is how to replace those lost returns – crucial if you need the income to maintain your standard of living.

The weekend money press looked at some of the options and brought their readers up-to date with what’s happening in the investment world. Apparently, people aren’t putting their money into hedge funds – quite the opposite it seems. The Financial Times said that investors pulled almost $150bn from these funds last month alone, as investors reacted to performance losses during 2008.

With-profits don’t appear to be a good thing either according to The Sunday Telegraph which reported that, according to Money Management magazine, one in five with-profits policies are returning less than cash despite decades of saving and the outlook isn’t improving. Norwich Union was the latest provider to announce large cuts of up to 18% on its policies.

The Mail on Sunday took a view on commercial property funds, saying that falling property values have obviously hit investors hard but that yields are increasing. The paper said that from its peak in May 2007 to November 2008 the MSCI World Real Estate Index – a measure of global commercial property – fell 47%, wiping out several years of good returns.

A dearth of lending has hit commercial property hard and the situation has been exacerbated by the recession, with concerns about tenants’ ability to pay the rent. However The Mail on Sunday quoted legendary investor, Anthony Bolton, who just recently has called the bottom of the commercial property market, citing the high yields attainable – anything up to 8-9% for quality assets – compared to the base rate and returns on cash. Bolton was quoted as saying that the high yields more than compensate investors for the risk that some tenants may go bust.

One other area investors are looking at is corporate bonds – effectively IOUs issued by companies. Leading fund managers Paul Read and Paul Causer of Invesco Perpetual gave their views on how they see opportunity in this asset class.

“The yields available in credit markets look outstandingly good value, almost irrespective of the economic outlook. Across good quality UK corporate names you can buy debt with redemption yields above 8%. In bank capital you can buy yields of 8%-12%. Corporate bonds are currently priced at levels not seen since the 1930s” was Read’s view, adding “The market is currently discounting unprecedented levels of default, whether you are looking at investment grade or high-yield corporate bonds. According to a recent study by Deutsche Bank, since 1970 the worst default rate in sterling investment-grade bonds over any five year period was 2.4% whilst the average was just 0.8%. At current spreads the implied default rate is 35%. In our opinion these levels look extremely unlikely”.

Don’t forget the yield on equity income funds – in many cases these are over 5%. On Friday the FTSE100 was yielding 4.76% and this of course is effectively net of basic rate tax liability. So for investors seeking to replace lost income there are fortunately still plenty of choices available.

Paul Read and Paul Causer also manage the St. James’s Place Corporate Bond Fund.

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