Grin & Bear It

Posted on: 15 July 2008 by Gareth Hargreaves

Financial markets were buffeted by a number of headwinds last week, explains expert Graham Kerner.

Stoicism and fortitude were pre-requisites for investors last week as global financial markets were hit by a wave of downbeat news and concerns over the health of two of America's largest mortgage institutions.

The week got off to a wobbly start with renewed volatility on Wall Street as energy and materials stocks were hurt by falling commodity prices, leaving investors to retreat into the more defensive industrial and pharmaceutical sectors.

The mood improved somewhat on Tuesday, according to The Financial Times, as oil prices fell sharply to $136 a barrel, with one chief investment officer commenting, "Oil falling $10 in less than a week is grounds for some optimism."

Some soothing words from the chairman of the US Federal Reserve also lifted traders' spirits. Ben Bernanke said that large US investment banks will be able to access emergency cash from the Fed into next year as long as the financial turmoil lasts.

Somewhat cheered, equity markets picked themselves up and rallied smartly. Earlier in the day the MSCI World index had touched its lowest level since October 2006, down some 20 per cent and putting it technically into 'bear' territory. Whilst there is no official definition for a bear market, price falls of this magnitude generally qualify.

Mr. Bernanke's comments were fortuitously timed, boosting not just Wall Street, but also London, where traders' concerns about Bradford & Bingley and the state of the housing market had driven prices down. Shares in the beleaguered lender had lurched downwards again as investors questioned the company's long-term value and hopes for a quick sale receded.

Over in the housing market, The Independent reported that, according to the Halifax, house prices have fallen 6.1 per cent over the last year - one of the sharpest falls since the Eighties. Despite low unemployment, relatively low interest rates and a shortage of new houses, uncertainty remains in the housing market, with potential buyers finding it hard to borrow, contributing to the slowdown.

Unsurprisingly, house builders have struggled this year, but news that Barratt Developments had secured new borrowing of £400m gave a much needed boost to the sector, with Barratt's own share price jumping 24 per cent. This was despite announcing it was scrapping its final dividend and cutting 1,200 jobs.

Against this backdrop it came as no surprise to the City that the Bank of England decided to hold interest rates at 5 per cent as policymakers grappled with the dilemma of slowing economic growth and surging inflation.

Freddie Meets Fannie

The real story of the week centred on America's two largest mortgage lenders - Freddie Mac and Fannie Mae.

Born out of the Great Depression, the Federal National Mortgage Association or Fannie Mae as it is colloquially known, was created in 1938 to help the housing market, becoming publicly traded thirty years later. In 1970 it was joined by Freddie Mac - the Federal Loan Mortgage Corporation - created as a competitor by Congress and today the two institutions account for around 50 per cent of the US home loans and have guarantees on c$5,000 billion of debt.

Although publicly-listed companies, both have a line of credit with the US Treasury and thus perceived by investors to come with an implicit guarantee that they are backed by the American Government. Like other lenders they have reported losses recently, hurt by the adverse housing market and losses from derivatives.

As an aside, hopes that the US housing market might have bottomed were dented last week after the National Association of Realtors index for home sales recorded a 4.7 per cent drop in may, more than anticipated.

On Thursday shares in the two companies plunged in frantic trading as investors jumped ship, unsettled by comments from a former member of the Federal Reserve who said the chances of a bail-out of both Fannie and Freddie were increasing. Both Hank Paulson, US Treasury Secretary and Ben Bernanke sought to re-assure the markets, with the former saying, "they play an important role in housing markets today and need to continue to play an important role in the future."

By Friday, shares in both companies fell further - losing around half their value - forcing the Bush administration to reaffirm support for them but, according to The Financial Times, quashed rumours that they would be nationalised.

Equity markets retreated in response to the concerns over the health of the lenders with sentiment further hurt by a $5 jump in oil prices - taking the price of crude to a record high of $147 per barrel.

However, as The Times reported at the week-end, events changed swiftly as President Bush was forced to wade in, saying his two lieutenants, Paulson and Bernanke, were "working this issue very hard."

The Daily Telegraph interpreted the situation differently, saying Paulson had ruled out a rescue of the two lenders despite the chairman of the Senate banking committee saying, "Fannie Mae and Freddie Mac are too important to go under. If they need additional support, Congress will act quickly." Amidst all the speculation about the health of these key institutions, markets nevertheless priced-in the cost of a bail-out by increasing the cost of insuring against default on US Treasury Bonds, which according to the paper would threaten the United States triple-A rating.

By yesterday it became clear that a rescue package was being put together - The Sunday Times reported that Paulson had lined-up some $15 billion of capital to be injected into Fannie and Freddie in an attempt to stem the crisis. Wall Street analyst Howard Shapiro told the paper that, "There will be government action, but it will be far short of the dire scenarios people were envisioning. There's no question that the two firms were fundamentally sound."

So, by the end of the week, traders and investors were looking for some respite from what was undoubtedly a tense time.

Aphorisms & Adages

Last week also witnessed the death of Sir John Marks Templeton at the age of 95 - he conquered Wall Street to become one of the world's greatest investors and philanthropists. Renowned for his pithy aphorisms, Sir John had a simple philosophy: "If 90 per cent of people are selling something it is probably undervalued; look in countries where other people aren't looking; and do the opposite of others."

He founded one of the first mutual funds in 1954 and on his retirement in 1992 that fund had annualised returns of 15 per cent. A shrewd investor, he famously bought equities the day after the 1987 stock market crash.

His best known saying is probably: "Bull markets are born on pessimism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell."

Another great investor, now retired from running the Fidelity Special Situations fund, is Anthony Bolton who, writing in The Sunday Telegraph, shared his thoughts as to what advice he might give private investors.

"These are my personal views. My recommendation is not to attempt to time the markets but to take a long-term view. History has shown us that the patient investor has been rewarded by the long-term uptrend. Trying to switch in and out of the stock market is very difficult and most investors who try it are worse off as a result. Our research shows that £1,000 invested 15 years ago would be worth £3,261 today if left untouched. Had you missed the best 10 days it would be worth £2,147 and only £885 if you had missed the best 40 days."

"You mustn't get bearish as the market falls. At the bottom of the market the outlook will appear worst of all. This is when the pressure is greatest - the point of maximum capitulation - and you may feel like quitting equity investment for good."

A useful reminder for anyone during these difficult times.

All Change

Well, the global picture certainly has in the last six months, so what are fund managers doing to respond to the emerging economic head winds? Alex Stanic of Newton manages global equity funds for St. James's Place and, whilst the environment has been challenging, Alex and his colleagues have weathered the storm remarkably well.

"It has been difficult, but with the fund producing positive returns in the last year compared to mostly losses elsewhere, our decision to focus on the emerging and developing economies has proved right. This strategy was formed on the back of a view that the era of rapid growth in the developed world funded by high levels of debt could not continue and has now evolved into a major new theme of 'All change'. The popping of the credit bubble has marked an end to the era of rapid growth and at the same time heightened volatility in financial markets and recent events have merely re-affirmed our views."

"The portfolio has mostly avoided financial stocks and still does, although we are actively considering investing in the banking sector - but I still have concerns about their need to raise further capital which will harm existing shareholders."

"Our approach to investing is theme driven and there are fifteen at present, although two are very nascent - 'More government' recognises that China and Russia are quasi-capitalist, but their governments are taking more control and there is more protectionism in the world. We're still thinking about how to take advantage of this change."

"'Uneconomic growth' is about unsustainable global growth policies. The emerging markets, by pegging their currencies [to the US dollar] mean they have been sheltered and able to keep their exports high. But they will have to curtail demand - already China has started reducing energy subsidies."

"High oil prices have created huge pools of money in the Middle East and it's not clear how they will spend this money - maybe on huge building and infrastructure projects. So again we're looking at how best to exploit these changes. These thoughts are encapsulated in our 'Construction and Reconstruction' theme where we think there will be not only spending by less-developed economies, but also in the developed world where, despite prolonged prosperity, important areas of infrastructure have been neglected."

"So we've been busy in the portfolio - selling some of our very profitable holdings where we have done well. Companies such as Occidental Petroleum, Genting Group (a Malaysian conglomerate), Ayala (a Phillipino company), Korean department store, Shinsegae and also the Indonesian bank BCA. This opportunistic profit taking means we have around 8-9 per cent less in emerging markets than earlier in the year."

"In turn we have been buying more energy related stocks because we think demand will remain strong. So we have acquired holdings in Talisman (Australian), Conoco Phillips and Constellation - a US energy business."

"Also more defensively, we have bought Roche, niche healthcare player Nobel Biocare and in telecoms, Brazil-based Oi: a sector where we continue to be overweight as we like the strong cash flows these companies have."

"So overall we have made incremental changes, taken profits and positioned the core portfolio more defensively. Recent events have not changed our mind-set and we continue to be confident about being able to grow the portfolio going forward”.

14th July 2008

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