Crunch time in the global markets

Posted on: 02 June 2009 by Gareth Hargreaves

The demise of what was once the world’s largest company, General Motors, made little impact on Wall Street where investors preferred to remain focused on economic recovery according to financial expert Graham Kerner.

Once the largest company in the world, US car maker General Motors will face an ignominious end today as it files for bankruptcy under America’s Chapter 11 laws. This will give the company time to put its house in order, selling off unwanted assets and closing plants before it emerges as a slimmed-down version of its former self. Whilst no surprise – the company has suffered from high production costs and falling sales for years – there are obvious implications, not least of which is the fate of its European arm Opel which includes Vauxhall here in the UK.

With the US government taking a majority stake in GM’s American business, Canadian motor parts group Magna will rescue the European arm and expectations are that the UK government will seek a guarantee that over 5,000 British jobs are safe. Wall Street took the news in its stride though, preferring to focus on the much awaited economic recovery even though data on the all-important housing market was not that encouraging. A record 9.1% of all US mortgages were delinquent at the end of the first quarter, according to the Mortgage Bankers Association. But whilst house prices are still falling, according to the Case-Shiller index, there are signs that housing starts and sales appear to be stabilising which reassured the market.

Here in the UK the fortunes of our own housing market seem to be improving. According to the Nationwide House Price index, prices rose for the second time in three months, up 1.2% in May and the largest one-month increase since 2006. However, Nationwide’s senior economist was cautious about predicting the bottom saying “Although the short-term trend in house prices has clearly improved, it is still too early to say the market is turning definitively”.

In recent weeks there has been evidence that the backlog of unsold houses may be abating – the Royal Institution of Chartered Surveyors key sales-to-stock ratio has been declining and estate agents are reporting an increase in enquiries and sales. The Sunday Times reported that the number of new mortgages approved for house purchases in May was the second highest in just over a year and there has even been anecdotal evidence that gazumping is back in the more expensive parts of London.

Away from the property market though, retailers are still finding the going tough as sales fell last month, but according to a CBI survey, the state of retail business is deteriorating more slowly and the sector remains upbeat about its prospects. The services sector is more optimistic too, with the CBI also finding that businesses were less pessimistic about the outlook – 27% said they were more optimistic compared with 12% saying they were less so. This was the first positive result since February 2007.

Feeling Queasy

Away from the real economy though, investors in the government bond markets have signalled that they are becoming increasingly uncomfortable about the ballooning levels of issuance by the likes of the US and UK governments. Whilst investors continue to buy newly issued bonds, they are demanding higher returns which in turn has seen yields rise. The Financial Times pointed out that over the past fortnight, the US 10 year yield has risen by half a percentage point and has gained more than one percent since the Federal Reserve announced in mid-March that it would buy $300bn of longer-term Treasuries under its quantitative easing (QE) policy.

The surge in yields also sent the fixed US 30-year mortgage rate above 5% - prompting speculation that the Fed may increase its buy-back to avoid recovery in the housing market being snuffed out. And it’s been a similar story for the UK where ten year gilt yields have risen to 3.75% - above where they were before its own QE policy started in March. The Bank of England recently announced it would allocate a further £50bn to the original £75bn earmarked for the purchase of gilts and corporate bonds as it strives to keep down the cost of borrowing for consumers and business. “The sharp sell-off in government bonds in the past couple of weeks is just the latest twist in a macroeconomic tango involving growth prospects, inflation fears and interest rates” commented Goldman Sachs.

Stressed Out?

Elsewhere in the financial markets sterling rose above $1.60 for the first time since last November, buoyed by renewed hopes that the worst of the recession is over. “The worst of the financial crisis appears to have passed so any renewed assault on sterling from a fresh plunge in banking shares looks unlikely” said John Higgins at Capital Economics. Last week the Financial Services Authority (FSA), which is in charge of regulating banks and ensuring they have sufficient capital to maintain their strength, released details of the so-called ‘stress tests’ it recently applied to the UK banking sector. The purpose of these tests was to see how the bank’s balance sheets could cope with a prolonged and deep recession.

In its scenario – not a forecast said the FSA – it envisaged the recession carrying on for another 18 months, the economy would shrink by 6% from peak to trough, unemployment would rise to 12% of the workforce and house prices would halve. The implication was that all the banks and building societies passed the test with their capital cushions not falling below 4% of assets even after such a hypothetical economic storm.

Equity markets enjoyed another positive week with all the major indices advancing, adding to the already significant gains since March – most leading stock markets have now seen three consecutive months of gains since their early March nadir. In the commodity markets the price of crude oil rose above $66 per barrel – its highest level since last October – after the oil cartel Opec’s upbeat assessment of demand conditions surprised the market, signalling that the global economy was moving ahead once more, especially in the Far East.

Indeed, Japan’s industrial production rebounded in April at its fastest rate for half a century – output surged 5.2% month-on-month, according to The Financial Times, fuelling hopes that the worst of the slump is now over. In India the economy expanded more than forecast in the first quarter of 2009, adding to evidence that the global recession is easing. So by the end of the week investors’ spirits were raised once more, enabling the FTSE100 to close at 4,417 and the Dow Jones Industrial at 8,500.

Staying Cautious

The rising tide pushing up cyclical stocks is encouraging the view that the market has touched bottom and the world’s economy is improving. But, according to The Financial Times, investment managers say it is difficult to forecast how long the upswing will last and where and when the peaks and troughs will come. The paper said that more sceptical observers claim markets are likely to remain choppy all summer and valuations likely to fall as companies face difficulty gaining credit, rising unemployment takes its toll and companies hoard cash. One investment professional who remains very cautious on the outlook is star fund manager Neil Woodford of Invesco Perpetual who famously refused to participate in the technology bubble of the late Nineties and for the last few years refused to own banking stocks.

Asked if he was adjusting his portfolio in the light of the recent stock market rally Mr. Woodford’s response was unequivocal. “Definitely not. My portfolio is still pretty defensively positioned and I remain comfortable with that – the market’s rally has been based on hopes that the worst of the recession is over and that we are on the road to recovery – that is not my view. The economy has to become much less dependent on consumer debt – we need to save more and spend less. We are living in very tough times. Banks and consumers are going to be unwinding their accumulated debts for many years to come and that means there is a lot more pain to come in the economy. One aspect that worries me is the sheer scale of government bonds now being issued to plug the deficit in the country’s finances. The figure is set to double within two years and that’s a gigantic number so I think the Government could struggle to find enough buyers for this huge pile of paper.

I don’t think we will see a ‘V-shaped’ recovery - I think a sustained recovery is still a long way off. It is no surprise that there should have been a slowdown in the rate of decline following the precipitous drop in global economic activity witnessed at the end of last year and the first quarter of this year – the so-called second derivative change. But a slowdown in the rate of decline doesn’t mean recovery is underway in my opinion. So in this environment you look for sectors that should prove resilient in tough conditions, such as utilities, tobacco stocks and healthcare stocks. I like companies such as National Grid which is yielding about 7%, GlaxoSmithKline with a yield of around 6.5% and BAT on 5%. I got out of banks several years ago because I was concerned about the sheer level of debt that was building up. That concern has now become a reality and I am still avoiding the sector – I think they will need more capital to repair their balance sheets. The Treasury is refusing to give full details of the recent stress tests exercise they carried out and that leaves me unconvinced.

The recent rally has obviously hurt my performance as it has focused around people buying banks, metals, mining and other cyclical sectors which I do not own. I do think the market is likely to give up some of its recent gains and I think my defensive strategy will continue to work over the coming months. There are a number of large stocks such as AstraZeneca and Vodafone which have fallen a long way that now look really good value. I think the outlook for income is very positive – the companies I own are well placed to maintain and increase their dividends so looking ahead I remain very confident for my portfolio”.

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