Fannie, Freddie And The Stock Market

Posted on: 09 September 2008 by Gareth Hargreaves

Graham Kerner digests a week of financial slumps and rallies.

Global stock markets endured a difficult week as concerns over the UK and US going into recession grew amongst investors, although Wall Street rallied on Friday on the back of a proposed rescue for mortgage lenders Fannie Mae and Freddie Mac.

At the time of writing the FTSE is up 199.5 points. It goes to show that trying to time the market is virtually impossible, and that time in the market is the real answer - the long term view is the only way.

Markets In Retreat

Global markets were buffeted by strong headwinds last week in the shape of poor economic data from across the Atlantic which was sufficient to send investors heading for cover.

It wasn’t all bad news though - the price of crude oil continued to head south towards $100 per barrel, taking the heat out of some of the inflationary pressures. Of course, the corollary of cheaper oil has been the appreciation of the dollar which has risen sharply in the last month - although some analysts, according to The Financial Times, believe that when oil prices stop falling the market’s focus may well switch back to the currency’s poor fundamentals.

In the meantime, sterling’s own weakness has given British exporters a fillip, with the pound now some 15 per cent cheaper against the greenback and some 20 per cent cheaper versus the euro. The Times pointed out though that, whilst business may benefit, a weaker pound means costlier imports and upward pressure on inflation, potentially making it more difficult for the Bank of England (BoE) to cut interest rates. But for now, business is ambivalent, preferring to focus on the opportunity for increased earnings and profits.

In the City, having made a confident start to the week, investors were subjected to a barrage of downbeat news.

The Organisation for Economic Co-operation and Development (OECD) weighed in, saying the UK is worst placed among the world’s major economies to withstand the impact of a global slowdown. The OECD said the sharp downturn in the property market and the country’s increased dependency on housing had led to the organisation forecasting stagnation for the British economy in the second half of the year.

The importance of housing has not been lost on the government which announced an increase in the stamp duty free threshold to £175,000, coupled with changes in benefit entitlement to those who lose their jobs. The Independent reported that whilst welcome, the consensus view was that more help was needed, although house building shares rose as investors mulled over the implications.

Yet a lot can happen in a week and the market’s mood soured when the Society of Motor Manufacturers reported an 18.6 per cent annual decline in sales during August with sales to private buyers, as opposed to fleet purchase, down almost a quarter.

The news coincided with an announcement by the BoE that interest rates were being kept on hold at 5 per cent for the fifth successive month, despite a worsening economic climate - more evidence of which came from the Halifax which said that house prices have fallen 12.7 per cent in the last year. For good measure, the up-market estate agent Savills forecast further prices falls of 15 per cent this year and next, with no recovery until 2010, according to The Times.

Whilst none of the news was a real surprise, investors decided to watch from the sidelines as share prices fell sharply.

The final piece of bad news came on Friday when the chances of the US entering recession heightened after the unemployment rate hit five-year highs and new home foreclosures rose to a 29-year high according to The Daily Telegraph.

In response to the worse-than-expected data, traders on both sides of the Atlantic took the red pen to share prices, sending the indices lower.

Yet whilst the bears had the upper hand for the week, The Financial Times highlighted the point that, whilst markets were worried about the global economy, talk that the US Treasury - subsequently confirmed over the weekend - was in the process of finalising a deal to shore up the beleaguered lenders, Fannie Mae and Freddie Mac, gave a late boost to Wall Street. Having spent most of the day trading in negative territory, the Dow Jones industrial index managed to rally sharply towards the close, finally ending the day higher.

The news came too late for London where the leading FTSE100 index succumbed to the accumulation of events that have led many to believe there is going to be a recession, according to The Financial Times, and meant that shares endured a pretty torrid week.

Signs Of Recovery?

Investors will be well aware that share prices around the globe have fallen over the last year, but The Sunday Telegraph wondered if a recovery could be in the starting gates, despite the plethora of bad news.

The paper pointed out that resource stocks - metals, mining and energy - form a significant part of the index and with recent falls in commodity prices these companies have dragged down the index. If they are excluded, the rest of the market has rallied some 16 per cent from the July lows and whilst the improvement needs to be sustained, could herald an upturn in the market.

The paper also reminded its readers to keep a close eye on what the directors of Britain’s leading companies are doing, as they have historically been a good barometer. Apparently, the ratio of shares being bought to those being sold by company directors is higher now than it was when the last bear market bottomed in March 2003. The current ratio of buys to sells is 13:1 - compared to the long-term average of 2:5.

Go With The Flow

With market volatility making it difficult to know which asset class to hold in the short-term, investors are looking to diversify and, as The Financial Times discussed, they are turning to thematic investments with long-term growth prospects - such as infrastructure and water.

The case for both is strong - according to the OECD, infrastructure spending needs to be $53,000 billion worldwide between now and 2030. Also, as population growth gathers speed and emerging markets turn to cleaning up water supplies, prospects for water companies looks promising too.

Both of these sectors are seen as non-cyclical investments, offering diversification in a portfolio and there are other assets which are either uncorrelated or have a low correlation to developed equities - such as timber. So for those investors seeking alternative investments there are plenty of opportunities.

One of the growth areas favoured by investors in recent times has of course been China, but according to one leading fund manager, India is the future for your investments.

The Telegraph reported that the country’s strong enterprise culture combined with a steadier rate of manufacturing growth has led Aberdeen Asset Management’s veteran head of equities, Hugh Young, to argue that the sub-continent is a better long-term bet than China.

"The biggest issue with the Chinese is that they have gone gung-ho into manufacturing with no control and wages have soared over the last ten years. Indian companies are more aligned to the interests of their shareholders."

Whilst share prices can be volatile, Hugh, who manages the St. James’s Place Far East fund, has been gradually increasing his exposure to the region.

Whilst economic turmoil may not seem an attractive environment to invest in high yield bonds - IOUs issued by companies - some experts claim otherwise, with the fear of companies potentially defaulting not deterring some fund managers who see opportunities to be had.

The Telegraph explained that investors are being highly rewarded for taking greater risk in these bonds because the market is pricing-in a much higher level of defaults than is likely to occur - 8 per cent, which is higher than the current level of 1 per cent and the predicted rate of 2 per cent for the year. The paper said that in addition to high income streams, a recovery in the economy will lead to a rise in capital values.

Two of the managers mentioned, Paul Read and Paul Causer of Invesco Perpetual - who manage the St. James’s Place Corporate Bond fund - are of a similar view, seeing the kind of opportunity that only comes along once every decade.

A Developing Strategy

Another fund manager who shares this view if John Innes of RWC Partners.

"By any measure the UK stock market is cheap; price earnings ratios are low and the yield on the market is almost equal to that of a ten-year gilt, around 4.5 per cent. In fact, the last time dividend yields were this high, gilts were yielding 8 to 9 per cent which puts current events into some perspective."

"There is another aspect too which should not be overlooked - many large corporations such as BP pay their dividends in dollars and sterling’s recent 15 per cent fall against the currency means an immediate uplift for shareholders and increases the attractiveness of owning equities."

"If we consider all the asset classes, government bonds are not compelling, as I’ve said, property is falling and returns on cash are likely to fall soon, but equities are cheap. So for me the decision is simple: to buy equities, despite the recent market setback, which has been caused by concerns over slowing growth in China as well as a recession in the West."

"Although I believe Britain’s share of global growth will decline over coming years, the developing world, in contrast, will continue to grow strongly. So I have to identify those UK companies that derive their earnings from overseas and the likes of BP is a good example."

"However, I do see opportunities for some British companies operating in niche UK markets - primarily those who are beneficiaries of government policy to outsource traditional publicly run services to the private sector. This is a major shift and still in its early stages."

"Capita is one such business I own and they have been huge winners in this market. As an example of the potential, they cited the fact that one major government department employs 4,000 people in its HR department - a service they could provide with just 10 per cent of the workforce."

"Another company I own is Balfour Beatty which has contracts to build new prisons, hospitals, schools and the Olympic Stadium."

"Businesses involved in outsourcing, whilst not totally recession-proof, will demonstrate resilience even if government expenditure comes under pressure."

"Coming back to my belief that billions of people are poised to become richer over the coming years, it is my job as a fund manager to exploit this change by investing in companies that will benefit from expansion in the developing economies."

"One needs to be careful not to get caught up in possible speculative bubbles - it worries me that an increasing number of FTSE100 constituents are foreign-based and dependant on maybe one commodity doing very well."

"I do own Anglo-American, a mining company but it is well-diversified and a properly run business. I have exposure to energy via BP and Shell, believing they offer extraordinary value, even though I think oil prices may fall back to around $80 per barrel. I like overseas property companies and own Carpathian - giving exposure to East Europe, and Macau Properties, a Chinese real estate business."

"There are plenty of opportunities for me, even though I operate from the UK, to generate profit from overseas economies. Recent volatility has not changed my strategy - I have actually made fewer decisions, preferring to remain cautious and concentrate on the long-term prospects and not short-term noise, waiting for this store of value to be realised."

John Innes manages the St. James’s Place UK Growth fund.

8th September 2008

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