Eye Of The Financial Storm

Posted on: 06 August 2008 by Gareth Hargreaves

Expert Graham Kerner takes stock of a week of bad news for banks and Britain's economy.

One didn't need to look too hard last week to find bad news. The press as ever provided a plethora.

In the banking sector, the numbers were predictably bad with profits at HBoS and Lloyds TSB slumping as a result of the credit crunch. Yet Lloyds TSB signalled confidence in riding out the economic downturn by raising its interim dividend and the market surprised analysts by marking up HBoS shares by around 10 per cent.

Is the worst over for the banks? Well The Sunday Times reckoned that RBS is poised to unveil the biggest loss in UK banking history after taking a hit of almost £6 billion from the credit crisis and the paper predicted there is more to come from the beleaguered sector.

Away from the storm the rest of the equity market sailed on, admittedly with a few ups and downs, to end the week slightly ahead as investors decided that much of the news was anticipated.

Some might find this surprising but for veteran investors such as Richard Peirson of AXA Framlington, the market's seemingly perverse reaction is familiar.

"I suspect that the headline news will continue to deteriorate for some while yet as the gloom deepens. But stock markets are good at discounting ahead of actual events and I would be surprised if markets went very much lower from here even if the economic outlook deteriorates further. I've held more cash than usual but there are some real value opportunities emerging which I am watching closely."

The point about things getting worse on the economic front before they improve was highlighted by The Independent which reported that the IMF (International Monetary Fund) expected losses from the credit crunch to hit $1 trillion. According to their latest report global financial markets "continue to be fragile and indicators of systemic risk remain elevated" and continued concerns about the weak US housing market lead the Fund to think that the banks will report some $1 trillion of losses as a result of the mortgage crisis.

Concerns over the parlous state of the US housing market meant that equity markets globally endured considerable volatility, with The Financial Times commenting that fears for the financial sector were stoked by news of more write-offs for Merrill Lynch and ANZ Bank. However nerves were soothed after the US Federal Reserve moved to bolster emergency liquidity measures to banks as it announced that the credit facility for primary dealers would be extended through to 30 January 2009.

The rest of the week's data on the US economy was somewhat mixed as the unemployment rate rose to 5.7 per cent last month, its highest level for four years. Whilst the data provided further evidence of deterioration in the labour market, the rate of decline was not as bad as predicted.

Notwithstanding the slowdown, the American economy still managed to grow at 1.9 per cent during the second quarter, up from 0.9 per cent in the first three months.

Blown Up

Hopes on the part of the authorities that inflationary pressure might ease received a setback last week when British Gas, the UK's largest energy supplier, announced a 35 per cent rise in gas prices. Higher energy bills will drive household inflation up from the current level of 3.8 per cent, twice the government's target, with the rate likely to peak at the 5 per cent level in the autumn according to some economists.

As an aside, the government's longer term plans for energy provision in the UK were dealt a blow when British Energy rejected a bid from France's nuclear energy company EDF. Part of the strategy had included plans for EDF to develop around four to five next generation nuclear reactors here in Britain.

Yet of course inflation is not just peculiar to the UK. Over in the eurozone rising oil and food prices have pushed inflation in the region to 4.1 per cent, an all-time high and more than twice the official target rate.

Unemployment too remains stubbornly high at 7.3 per cent with some big differentials between member states according to The Independent. In Spain, following the property sector collapse, unemployment is 10.7 per cent compared to 2.8 per cent in the Netherlands.

The ECB (European Central Bank) raised interest rates last month by a quarter-point to 4.25 per cent and with continued hawkish noises from the bank about inflation being the priority, most analysts believe rates will be held until 2009.

The extent of the economic slowdown in the UK became more apparent last week with The Financial Times reporting that company administrations have jumped 60 per cent since this time last year as rising interest costs, falling consumer demand and higher commodity prices prove too much for some businesses.

There may be some respite ahead though with signs that commodity prices are cooling - oil stabilised last week at $125 per barrel, down from its peak of $147pb in July and it is a similar story for other commodities. Last month witnessed some record price drops - rice and copper were down 4 per cent, wheat fell 6 per cent and oil fell 13 per cent in total.

There is a rising belief that the five-year long commodity price boom is coming to an end - if right, this should ease pressure on the Bank of England to raise rates. It meets this week and the consensus expectation is for rates to be left on hold.

Follow The Leader

Whether the awful figures from the banking sector signal the sector's nadir is as yet unknown but the fact that the index of the UK's leading companies remained broadly unchanged might, as already discussed, indicate that stability is returning to the stock market.

The Sunday Times mulled over the likelihood of this being a turning point and a time to buy. According to the paper, directors are increasingly confident the market is near the bottom.

In recent times the ratio of those buying versus those selling has been increasing and last week the ratio rose to 13 to one - compared to a long-term average of 2.5:1 and 10:1 at the end of the last bear market in 2003. More broadly, the price earnings ratio for the UK stock market, one measure used by professional investors to gauge value, stands at 10.5 compared to an historical average of 17 over the last twenty years.

Also the dividend yield on the UK market is 4.4 per cent, which is expected to rise to 4.8 per cent by the end of the reporting season, and close to the current yield on a ten-year gilt of 4.9 per cent. Back in 2003 the market turned when yields rose just above that of the 10-year gilt.

The paper's experts concluded that with so much cash around, and sovereign wealth funds come to mind, sooner or later it will be ploughed back into equities, pushing the market higher.

Patience Is A Virtue

Vacillating markets are disconcerting, even for professional investors like John Hodson of THS Partners but experience tells him that the best course of action is to continue with their long-term strategy and make opportunistic investments as they arise.

"One of the outcomes of the credit crunch has been increased volatility in the equity markets which has been caused by a bigger impact of speculative money in a less liquid market and I doubt if this will change in the short-term."

"The economic outlook remains as it is - the US authorities have done what they needed to by supporting the banking system with the banks themselves recapitalising and I do think we will see consolidation amongst the smaller to medium sized US regional banks. The US economy has slowed and that trend is likely to continue for a while but the housing market has probably fallen far enough. There are some tentative signs that in areas which have been badly hit - such as California - there is evidence of a little increase in turnover which is positive."

"Here in the UK we are seeing a slowdown too although the authorities have allowed a quiet devaluation of sterling against the euro of around 20 per cent which helps both soften the blow and aids exporters. Around two-thirds of UK exports go to Europe so this is significant for manufacturing but also means imports are more expensive, slowing demand and helping curb inflation."

"Also Chinese inflation means the cost of imports from the region are more expensive for UK consumers but the authorities there are working towards cutting the country's inflation rate. This will mean a bit of reduction in economic growth so I see a small global slowdown ahead."

"As to the portfolios we have been sticking to our theme-driven strategy, putting a little more money into the larger insurance companies for example, as the sector suffers from negative sentiment. Swiss Re upset the market recently because of its large portfolio of Fannie Mae bonds but there was never any doubt that the US authorities would bail the mortgage company out. Concerns about the quality of underlying assets have obviously hit financials hard but insurance is a more stable business and pretty recession-proof. We've bought a couple of Chinese companies recently - the heavy falls in equities this year has allowed us to buy back Bank of China for instance."

"Elsewhere as I said, the banks are recapitalising but there is some scepticism about whether these efforts will suffice if there are bigger problems with credit defaults. But taking RBS as an example, the bank made it clear to us that although it would have been painful, they could have coped with the sub-prime write-downs in isolation but combined with a UK slowdown they needed to raise cash to meet future demands. So actually although they expect to see their Tier 1 capital ratio come down a little to 6, allowing for UK write-offs, this is still well-above the old ratio of 4. And they don't expect their mortgage book to be hit too badly even though house prices will continue to fall."

"As to how long it is before we see things picking up, well last time round it took 18 months for the crisis to pass so being a year into the current one I guess it will be early next year for clearer signs."

"However we are seeing some corporate activity which is encouraging and a sign that prices are pretty rock bottom. The Santander bid for Alliance & Leicester is a good example of a successful business picking off a weak rival."

"So in the meantime patience is required and we are using the time to quietly invest some of the cash we have into businesses we feel are high quality but very cheap."

Richard Peirson and John Hodson both manage funds for St. James's Place.

4th August 2008

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