Banks & Barrels Crunch Consumers

Posted on: 14 June 2008 by Gareth Hargreaves

Financial expert Graham Kerner examines the outlook for markets this week.

Banks & Barrels Crunch ConsumersThe UK banking sector came under more pressure last week when Bradford & Bingley issued a profits warning and took the extraordinary step of re-pricing its rights issues. Its problems are likely to impact further on the buy-to-let sector where it is one of the largest lenders.

Oil spiked up last week to a record high of $139 per barrel partly on geopolitical concerns and also because of dollar weakness.

Vacancies at B&B

The aftermath of the credit crunch continued to make itself felt last week as troubles continued in the banking sector.

The UK's largest buy-to-let mortgage lender, Bradford & Bingley, upset the market firstly by announcing a profits warning because of rising arrears on its mortgage book and secondly, by taking the extraordinary step of renegotiating its £300 million rights issue. News of more difficult trading conditions in isolation was bad enough, but re-pricing its planned rights issue from 82p to 55p stunned the City according to The Financial Times, although in the background the FSA and Bank of England were 'closely involved'.

B&B also announced that private equity firm Texas Pacific Group would take a 23 per cent stake in the company at a price of 55p - hence the necessity to re-think the rights price and effectively allow the underwriters to walk away. However, some observers said that the deterioration in B&B's trading performance caused the bank to re-think its capital raising plans amid fears that the underwriters were likely to claim there had been material changes and that they were legally entitled to walk away. Unsurprisingly, shares in the once bowler-hatted building society collapsed, falling 24 per cent as investors voted with their feet.

The implications of B&B's problems were not lost on The Financial Times, which pointed out that the bank's problems are likely to see it retreat further from the buy-to-let (BTL) market. The paper pointed out that the landscape was already looking pretty tough for BTL investors with the sector particularly hard hit by the credit squeeze causing lenders to withdraw from the market. Mortgage Express, B&B's subsidiary, accounted for around a quarter of the BTL business, but was forced to withdraw its entire range of products and re-price many of its rates more than half a point higher. Market analysts believe that others could follow suit and so make life even more difficult for the hard-pressed sector.

Happy Birthday!

Last week the European Central bank celebrated its 10th anniversary - but not in the way most analysts would have liked. Jean-Claude Trichet, the ECB's president, upset the market by explicitly raising the prospect of a rise in Eurozone interest rates next month - confounding the consensus view that the next move would be down.

"M. Trichet's press conference was extremely unusual and left most observers stunned and bond markets reeling," said Marco Annunziata, chief economist at UniCredit.

M. Trichet's remarks, that the bank was in a "state of heightened alert", reflect increasing concerns of central bankers about rising inflationary pressures which are taking precedence over possible concerns about slowing economic growth in the region. In fact growth has been surprisingly robust, according to the International Monetary Fund, which has been forced to revise upwards its 2008 growth forecast for the eurozone and said the ECB was right to keep interest rates on hold.

Stuart Mitchell manages the St. James's Place Continental European fund and contrary to many commentators doesn't believe that the ECB will cut rates in the foreseeable future, notwithstanding M. Trichet's remarks.

"The European economy is in much better shape than most people realise. With the exception of Spain the region is enjoying continued good growth with the German powerhouse - the world's largest exporter - running on all four cylinders despite a strong currency. The reason is that most major German companies, with the exception of BMW, have relocated production plants to source cheaper labour. Europeans are not as indebted as their Anglo-Saxon neighbours which means they have more discretionary income and are not dependant upon the property market in the same way as the UK. Against this backdrop I don't believe the ECB will cut rates whilst it maintains its hawkish stance towards inflation.

"There are many exciting opportunities out there and two of my largest holdings sit around the demand for energy and food.

"Baywa is a German agribusiness supplying the entire German market and the huge rise in soft commodity has benefitted it enormously.

"Seadrill accounts for around 5 per cent of the portfolio. It is a Norwegian company and global market leader in supplying the technology to enable offshore oil reserves to be developed. During the 1990s the oil majors ran down their oil drilling capacity so there is now an undersupply, and with two of the world's most recent and possibly largest finds based offshore in Brazil and Angola, the company is well placed.

"The market has been difficult in recent months, but I have concentrated on the basics and have been careful not to make short-term investment decisions in response to market volatility. Looking ahead, I remain confident that there is growth to come out of Europe for investors”.

Oil Gushes

It was the energy theme that took front stage for global equity markets last week, with the price of oil once more resuming its seemingly inexorable rise. The Daily Telegraph reported that the price of crude oil was catapulted $11.18 to a new all-time high of $139.97 per barrel at the end of last week, amidst fears that Israel is preparing for outright conflict with Iran in the Gaza Strip.

As a consequence, there was a rush by traders to buy, creating a febrile atmosphere which resulted in the New York Mercantile Exchange suspending some of its heating oil contracts after prices broke through their daily limits. Perhaps stating the obvious, a senior energy analyst at Paribas said, "It's still a bull market in oil”.

The ramifications of sky-high oil prices prompted The Sunday Times to say that the UK economy is facing a severe “stagflationary” shock, with a rising risk of recession or economic stagnation alongside high inflation. The fear of the latter meant the Bank of England left interest rates unchanged when it met last week.

The paper said that the view held by some, that the sharply rising price is indicative of a speculative bubble that will soon burst, may well be right, but so far few investors have been prepared to bet against it.

At their meeting in Japan last week, energy ministers from the Group of Eight industrial nations called on oil producers to increase output to reverse the sharp increase in prices and US energy secretary Sam Bodman called for a removal of energy subsidies to limit demand growth - India removed some subsidies last week.

The alarm bells are ringing it seems in sectors directly exposed to the oil surge - the boss of Ryanair expects several European airlines to go out of business and the haulage industry is urging the government to stop new European rules that allow foreign haulage firms to compete for UK work.

One of the positive outcomes of higher prices, according to The Sunday Telegraph, is the likelihood of a second oil boom for the North Sea, with experts saying there are still about 25bn barrels beneath the seabed. Higher oil prices are now making it economically viable for producers to think about resuming offshore production where conditions are notoriously difficult and make it expensive to drill for oil.

Not Working

Part of the oil price's surge was a result of weakness in the US dollar, which came under pressure after the release of the latest US unemployment data. As The Times reported, the latest data showed that the number of Americans out of work rose by the fastest rate for 22 years to 5.5% - up sharply from the 5% recorded for April. The rise, which equates to 49,000 people losing their jobs, was the largest increase since 1986 and means the jobless rate is at its highest since 2004. On Wall Street a much smaller increase had been expected so the data gave traders a nasty jolt, which caused a stock market sell off and overflowed into the currency market. Many economists believe that unemployment will continue to rise, although the US Federal Reserve is expected to hold interest rates steady after cutting them seven times since last September-cumulatively by 3.25%.

So, after the week's travails, global equity markets gave ground to end mostly lower with the exception of Tokyo which managed to advance 1% as investors continued to buy cheap stocks.

High Octane

Richard Oldfield is one of the managers of the recently launched St. James's Place High Octane fund and he holds a concentrated portfolio of just ten stocks.

"There are four pillars to my current strategy. Firstly there's Japan where I own Canon and Oryx. I like Japan because the background is changing - the era of consensual politics which has resulted in snail-pace change is becoming more lively.

"Secondly, corporate governance is changing for the better - with companies becoming more Western in outlook. Sony and Nissan both have Western CEOs - unthinkable five years ago. Because foreign investors have become frustrated over the years they have given up on Japan and consequently the market is cheap and good companies such as Canon and Oryx are very cheap but ultimately, low valuations will out and around 22% of the portfolio is invested there.

"Next is what I call Quality Growth - companies with historically high returns on capital, with strong balance sheets, but which trade on moderate multiples because of concerns over future earnings. These are usually household names across a broad band of industries and here Canon fits the criteria and also Johnson & Johnson. Around 26% of the portfolio is invested in this theme. Then there is gold and here I own Barrick Gold - around 6% of the portfolio and which I am looking to increase significantly. It is a classic environment for gold - a weak dollar, inflationary pressures and financial stress and I believe the metal has much further to go. Barrick is the world's largest producer and will enjoy a step-change in earnings power following its decision to stop selling forward its production last year. It means that the company will now receive the going market rate as opposed to, for example, the $512 per ounce it earned a year ago against an average spot price then of $640.

"Lastly are stocks for The Brave and here I would put RBS and US house-builder D R Horton - both sectors have been pounded as a result of the credit crunch and the stocks are very cheap, but on my own conservative assumptions, I think there is value there. D R Horton has a market cap of $2.2bn, but with free cash-flow of $1bn and it can use the cash it is accumulating, through its sales and by not building, to buy up distressed companies in the sector. It might look ugly in the short-term, but in a couple of years time things will look great. So my approach is to use the current adverse climate to buy quality stocks at low prices - and then be patient."

9th June 2008

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