Financial Market UncertaintyPosted on: 14 October 2008 by Gareth Hargreaves
Finance expert Graham Kerner takes stock during worrying times for investors.
There are few people in the UK who will not be affected by the current events in financial markets, especially if they have investments or are contributing to pension plans. Even investors holding cash on deposit are wondering if they are safe!
This special investment bulletin reflects both the reasons behind the ongoing market volatility and the thoughts of a number of leading fund managers, who have experienced similar market conditions.
Take A Deep Breath
The events witnessed in the financial markets last week have been viewed by many observers as being unprecedented but it is important to remember that every bear market unfolds in a different way.
No doubt some readers will be able to recall similar times, perhaps the Crash of 1987, when prices fell sharply. So whilst current events are understandably disconcerting, we have been through - and more to the point, survived - other financial crises.
"Time is a good healer, many people have forgotten the Latin American debt crisis back in the Eighties. It was much worse then because on paper, virtually every Western bank was bust. That is not the case this time," was the view of veteran City investor, John Hodson.
The week was though unprecedented in terms of the reaction to the crisis by world financial leaders who, in a concerted effort, agreed plans to help those banks in difficulty recapitalise so they could continue lending. Steps were taken to increase liquidity into the financial markets and crucially central banks cut interest rates in order to mitigate the effects of a global economic slowdown.
In the UK Alistair Darling's plan was seen as an original and positive step towards solving the problem - the US and eurozone countries have followed suit, committing themselves to providing funds on whatever scale is needed to ensure stability.
Whilst there will be a time-lag before the benefits of these policies work through these actions should ultimately restore confidence back into the markets.
John Hodson also added, "The last banking crisis in the 1990s took about 18 months from start to the point when confidence came back into the market. The current crisis started in July last year so I guess we are well over two-thirds through this today".
So as you will read, whilst we report what happened last week, events do need to be seen in context and indeed European markets have opened significantly higher this morning in response to the co-ordinated rescue package formulated over the weekend.
The credit crisis made what looked to be a final convulsion last week as investors' nerves finally succumbed to growing concerns about the state of the global financial system and economic outlook. As the week progressed, stock markets around the world headed south, despite concerted action by world leaders to stem the panic, which finally ended in a rout on Friday.
Most major markets ended with significant falls - in London the FTSE100 suffered its largest fall since 1987 and it was a similar story around the globe.
Even Japan, which has been in the doldrums for years, the market lost almost a quarter of its value after stocks plunged to depths described as "frankly beyond our imagination" by prime minister Taro Aso.
Yet there was a tiny glimmer of hope on Wall Street which, although it fell sharply, bounced from its lows on Friday as hopes rose that the US Treasury would take further action to restore stability when Hank Paulson announced that the government will purchase equity in a large number of banks if necessary.
The last two independent investment banks Morgan Stanley and Goldman Sachs saw their shares mauled last week, raising concerns about their financial well-being but as The Sunday Telegraph said, it is almost a certainty that Morgan Stanley will be bailed out.
To the outsider, events have understandably been bewildering and The Financial Times helped its readers by trying to explain in simple terms what exactly is going on. In essence the US and Europe are in the grip of a credit crunch because banks no longer have enough money to lend, so it has impacted on the consumer and specifically the housing market.
Up until the last week action taken by policymakers appeared fragmented and reactive which is why financial markets were unconvinced. On the one hand some US institutions have been rescued - Freddie Mac, Fannie Mae and AIG - whilst others were allowed to go to the wall such as Lehman Brothers. The latter decision has, with the benefit of hindsight, proved to be misjudged. Much of the uncertainty which caused last weeks falls can be attributed to this, now bust, investment bank.
As The Financial Times went on to explain, there were growing concerns at the beginning of last week about the amounts that will have to be paid out on credit default swaps - a form of insurance against bond defaults - linked to Lehman Brothers. Estimates have ranged between $350 to $400 billion. The failure of the bank has put pressure on its counterparties to buy more credit insurance just as confidence in the market is waning. The paper explained that many investors had positions with Lehmans but which now have to be terminated and the markets are unsure whether the insurers will be able to meet the bill. Many of these positions needed to be reset with other counterparties, sometimes at a loss, hence the worries in the markets on Friday.
Policymakers Act Decisively
Hopefully last week will be seen as a turning point for the financial markets on what admittedly is likely to be a long road to recovery following concerted efforts by policymakers across the world to find a solution.
Last week Gordon Brown announced an unprecedented package of assistance to UK banks in an effort to restore confidence and repair the damage. The government has promised a huge cash injection totalling some £400 billion. The imaginative rescue plan will see up to £50 billion of new capital being made available to help banks recapitalise and boost their balance sheets which will, in turn, enable them to start lending again.
Over the weekend it was announced that RBS, Lloyds and HBoS will seek help from the government - in return the government will effectively become a major shareholder and own preference stock in the banks.
Barclays is seeking funds from private sources and shareholders.
In addition to this an extra £100 billion will be available for short-term loans topped up by a further £250 billion in loan guarantees which will enable banks to exchange bonds that they own for either gilts or short-term cash.
With the pace being set by the British government, news emerged that there will be a concerted effort by eurozone finance ministers to put together a similar package to assist European banks who need to re-capitalise. Whilst the numbers have yet to be agreed the fact that the eurozone is adopting the UK template is reassuring and should make a significant step towards stabilising the markets.
"I see these recent events as a positive and major step to recovery," was the opinion of John Hodson, a view echoed by star manager Neil Woodford. "The crisis has reached pretty mammoth proportions. Central banks know how to get out of this problem. The solution is in hand," he said.
There was also a co-ordinated move by the world's most important banks as they announced simultaneous interest rate cuts in an effort to avoid a severe global recession.
The Bank of England cut the cost of lending by half a percent and the likes of HBoS quickly passed this on to its borrowers, cutting its variable mortgage rate by a similar amount. Further cuts are likely in the months ahead with many experts predicting rates may fall as low as 3.5 per cent by next year which would give a much-needed boost to the struggling property market.
In the US the Federal Reserve cut rates to 1.5 per cent and in the eurozone the ECB, which only recently raised rates, cut its policy rate to 3.75 per cent. The move by central banks helped to temporarily stop equities falling albeit briefly with investors remaining skittish.
With the threat of global recession China has decided to take part in "close co-operation" with the West to maintain stability of the global financial market according to The Sunday Telegraph. China is the second largest holder of US treasury bonds and there were concerns that Beijing would flee the dollar but instead now looks likely to buy a further $200 billion to boost the bail-out plans.
The credit crisis gave no quarter last week, claiming another casualty in the form of Iceland's banking system which effectively collapsed as the government was forced to announce the nationalisation of the country's banks. The collapse resulted in accusations by the Icelandic government that it was a direct result of action by the UK government to take control of the bank's UK subsidiaries.
Fortunately, British savers in the collapsed Icelandic banks will be protected after the Chancellor's commitment to protect fully the deposits - over and above the recently increased £50,000 limit of the UK Financial Services Compensation Scheme. As The Financial Times said, it is now implicit that the government will act to protect savers regardless.
Less fortunate are likely to be the pension funds of Britain's local councils who collectively, according to The Independent, have invested some £1 billion with several Icelandic banks. Currently their deposits are frozen pending negotiations between the two governments, but Alastair Darling has warned it was unlikely to bail them out.
After the traumas of last week it is now clear that with action being taken at the highest level there are some grounds for cautious optimism that the world is on mend. So how do some of the investment professionals see events?
Ian McVeigh manages UK equities and gave his view last week. "It's a pretty bloody backdrop against which to be investing at present - shares are very pessimistic about the economic outcome. The markets seem to be as downbeat about emerging markets, which have become frothy, as they are about developed economies with expectations of zero growth."
"This seems extraordinary to me, but does create great investment opportunities because with the pervading gloom I can buy companies like BP which yield 7 per cent - more than a ten-year gilt. What the market is really saying is that BP will not grow its business over the next ten years, which I don't believe."
"There are plenty of others too yielding similar amounts - Rolls Royce, Vodafone and other blue chips. Now if you don't think these companies will be around in ten years time then you're right not to own them but I don't subscribe to that view.
"I've been buying selectively, recently adding J Sainsbury - it's a prime retail business with huge land assets and the current price sees it trading at a 40 per cent discount to net asset value even after those assets have been recently marked down by 30 per cent."
"The key to things getting better is the LIBOR spread: it's inconceivable that this won't narrow. This week's interest rate cut will help things and the £400 billion government package will enable banks to re-capitalise. The message to the banks is clear in that the government will ensure that sufficient funding is available to facilitate the likes of HBoS rolling-over a significant part of their mortgage book before the year end."
"State-based intervention is not ideal but action was needed although we have to realise that there will be a time-lag before these new policies start to work."
"A key indicator will be the US housing market where new starts are at a low despite the fact that, because of demographics, there is a need for a net 1.1 million homes each year and housing starts are currently well below that figure. So an increase in homebuilding is a good lead indicator, albeit with a six to nine month time lag but it will help stabilise the economy, increase confidence and lead to increased borrowing and lending. For now, we just have to wait".
Richard Peirson has been through many recessions and bear markets so is no stranger to challenging market conditions. "Volatility in the market is huge with prices moving 10 per cent within a day - years ago a 5 per cent move would take six months to happen."
"Clearly there is a huge weight of selling but one thing that gives me comfort is that it is forced selling by hedge funds and their ilk who have to unwind their derivative contracts linked to Lehmans. I have been talking to a lot of other fund managers I know and no-one thinks the market is expensive, indeed taking an 18 month view, shares are screamingly cheap. So the selling we are seeing is taking place for technical reasons, not for fundamental reasons."
"A fund manager's job is to take a view on a stock but in the current environment it is increasingly difficult to form a view with any confidence but I have continued to trade for the portfolio despite the frustration."
"For example, a bank I have traded for many years is Standard Chartered and a while back I sold at £16.60 and this week bought it back at £11.50 yet today this is down a £1.00. It is a well capitalised bank, doesn't need to draw on the new government scheme but still fell, which illustrates that there have been no hiding places."
"There are other similar examples in the portfolio such as Smith Industries and EDF. The latter company is subject to an accepted takeover offer at 774p and I bought at 723p, giving a known upside - better than holding cash - yet even this fell."
"But I'm continuing with my strategy of buying big stocks on bad days because the market can whipsaw as violently on the upside as it can on the downside, so whilst current events are unsettling I'm not behaving like a rabbit caught in a headlight. The portfolio is as liquid as it has ever been - lots of cash - around 12 per cent - and about 18 per cent in gilts so almost a third of the assets in total."
"The economic outlook is deteriorating and we must expect a global slowdown, which means we should expect the headline economic news to be poor over the next twelve months. However, the markets have priced-in a recession, the banking problems are being addressed and whilst not out of the woods yet equities, as always, will lead the recovery".
What about the impact of the events in the West having on the East? Hugh Young of Aberdeen is a veteran investor in Asian stock markets, has experienced volatility before and sees no reason to get particularly worked up over the latest bout.
"We have become rather phlegmatic over the years, having seen the Asia crisis in 1997 when things really did fall of the edge of a cliff. The current crisis is far from the end of the world but the West is in a mess".
Hugh's conservative investment approach stands him in good stead. "Being cautious tends to pay off."
"I was slow to get into China's boom. When everyone was piling into Chinese stocks last year during the bull run we were underperforming and even looked foolish."
"But now the markets have plunged we could have taken more off the table." The Chinese market has lost two-thirds of its value this year.
"We do our homework and stick to our comfort zone where we have confidence in companies and managements. Then when the going gets tough we do well. Equity earnings are going to be under pressure next year, but our companies are doing well in these tough times".
Clearly there are reasons to be more optimistic but undeniably here and now investors will be mulling over their options. Without exception, the unequivocal message from the experts quoted in the media were saying that investors should sit tight and remember that they are invested for the longer term.
At these prices, as The Sunday Times pointed out, stock markets are now firmly pricing-in a global recession with some share prices at their lowest levels for a generation. The paper said that if you had a clear rationale for your portfolio, in terms of your attitude to risk and timescale, you should ride out the storm.
The £400 billion rescue package is likely to be copied globally which the paper's experts thought would mark the bottom of the market and usher in a sharp bounce-back. Company directors seem to agree, having been buying their own shares with gusto - last week the key buy-to-sell ratio spiked to a high of 25-1 compared to a long-term average of 2.5-1.
All of the investment professionals quoted manage funds for St. James's Place.
13th October 2008
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