Rays Of Light Amid Economic Gloom

Posted on: 14 April 2008 by Gareth Hargreaves

Graham Kerner reports on this week in finance, including news that interest rates are down, but so are house prices.

Some good news for the economy this week is that the UK is still expected to grow and any US recession is likely to be mild.

The Bank of England cut interest rates by a quarter of a point last week, not enough some felt as lenders continue to raise their own rates. The Halifax reported a 2.5% drop in house prices in March, surprising many on the downside. Problems in the housing market have galvanised the government into action with promises of help from Alistair Darling.

Slowly Does It

Equity and credit markets were struggling last week as concerns about the slowing global economy kept fretful investors on the sidelines. Midweek, the International Monetary Fund (IMF) announced that it had cut its estimates for global growth, challenging the relatively bullish views of national authorities and central banks. The IMF is forecasting that the US slowdown will last longer than most thought but said that it did expect a "slow recovery" and that the US Federal Reserve "may well need to continue easing interest rates for some time".

Growth in Europe and the UK is also expected to slow but in aggregate expectations are for the global economy to continue growing, albeit less briskly than in the last few years. The Independent reported that here in the UK the government's forecasts are looking increasingly optimistic and the National Institute of Economic and Social Research said that the latest IMF forecast of 1.6% growth for Britain would have "rather nasty" effects on public finances.

However writing in The Sunday Times economist David Smith argued that the outlook may appear gloomy but that the world is not about to "go pop". Smith said that whilst the IMF might be forecasting a slowdown in economic activity, a recession is unlikely - the institution is predicting US growth of around 0.5% which, whilst weak for Americans, implies only a mild recession.

One reason things feel a little down is because the balance of growth has shifted from the advanced economies to the developing world: the IMF expects the latter to grow smartly at 6.7% this year and the likes of China are more worried about inflation than recession.

Smith said as for Britain, growth of 1.6% would put us ahead of not just the US but also Germany, France, Italy and Japan. So whilst it may not be a great prize to win as such, Britain is likely to vie with Canada to be the strongest-growing economy in the G7.


Meanwhile away from the world of forecasting global equity markets endured a rather choppy week with the recent rally running out of steam according to The Financial Times.

Both stock and credit markets closed on a weak note after US behemoth General Electric - viewed as a bellwether stock for the health of the US economy - surprised investors with its first quarterly profit drop in five years. The huge conglomerate also lowered its 2008 outlook despite the fact that, as The Daily Telegraph noted, its chief executive Jeff Immelt recently told investors that profits for this year were "in the bag". The news was sufficient to wipe $42 billion off the value of the industrial and financial company and also damage sentiment in the wider market, causing the Dow Jones to fall over 200 points. Despite Mr. Immelt saying "we hate disappointing investors" shocked traders sold shares in GE causing the price to fall some 12%.

Unsurprisingly the news damaged sentiment across the board with a UBS analyst commenting, "GE's earnings disappointment is example number one of how big a pall the housing industry casts over the overall economy."

In London shares went into reverse on the news, meaning the FTSE 100 lost most of its gains for the week although it did manage to stay in positive territory overall.

Away from the equity markets the dollar and pound came under pressure while among commodities, oil and rice prices set record highs with crude oil touching $112 per barrel.

However there was some optimism that credit markets have stabilised according to The Times. The paper said that banks and governments raised almost €33bn in the European bond markets last week in a sign that confidence is returning to the long-term debt markets for the first time since the credit crunch hit last summer.

Going Down

After weeks of mounting evidence that the UK economy is beginning to slow it came as no real surprise when the Bank of England's Monetary Policy Committee (MPC) announced a quarter point interest rate cut to 5%. Some observers had hoped for more but the Bank's governor Mervyn King is still worried about inflation as the key Consumer Prices Index jumped 0.8% last month to 2.5%, above the long-term target of 2% set by the government. Against this backdrop the MPC took the view that it should continue with its softly, softly approach to reducing the cost of borrowing.

The rate cut was treated with some contempt by the mortgage-broking community as The Times pointed out. "This was a good opportunity to knock at least half a point off the base rate. A quarter-point cut will only offset the increases that lenders have initiated in recent weeks. There is no guarantee that they will even pass on this cut to their customers," commented Cobalt Capital.

The latter point has not been lost on the government with Gordon Brown ordering a crucial bank summit this week according to The Sunday Telegraph. The Prime Minister's decision to intervene comes hard on the heels of news that the housing market went into reverse again last month and fears that paralysis has hit new mortgage lending.

The Financial Times reported that a stark warning from the Council of Mortgage Lenders to homebuyers that mortgage lending could halve this year, prompting a pledge from Alistair Darling that the government would do everything possible to restore normality to the market.

Brown's summit will apparently be attended by all the major lenders and will focus on the state of the housing and interbank borrowing markets. It will also look at a potential "kitemarking" solution that would help identify the highest grade mortgages for money-market investors.

Major lenders have continued to tighten their lending criteria making it increasingly difficult for borrowers to raise sufficient capital to buy a home.

The MPC's decision to cut rates came at a propitious moment though. On Tuesday the country's largest mortgage lender Halifax Bank, stunned the market when it reported a 2.5% fall in property prices during March - the largest fall in house prices for 16 years according to The Independent.

However some economists argue that things are not as bad as the media say - Liam Halligan writing in The Sunday Telegraph said that the property market is slowing but the Halifax numbers are based on loans the company has offered. However a high proportion of house sales don't involve a mortgage and the credit crunch means a shrinking mortgage sample thus distorting surveyors' valuations. This argument found some support in The Financial Times which said its own House Price Index showed that prices were flat in March, marking it as the fourth month out of five where almost no growth was seen. On an annual basis though house price inflation is still positive at 5.4%.

Plenty of Opportunity

The turbulence in global financial markets this year has of course unsettled investors and for investment managers it has been a challenging time, even for veterans like Neil Woodford of Invesco Perpetual who runs UK equity income funds, and manages money for St. James's Place.

As The Sunday Telegraph commented, even in these difficult times the nation's dominant AAA-rated fund manager believes there are still opportunities out there for wise investors. The paper said his exceptional performance has been achieved even though he has been one of the most bearish investors, consistently positioning his portfolio of shares in a defensive way and backing companies with strong cash flows.

As he explained, one of the reasons he remains optimistic is that he believes there are still opportunities for mergers among large UK companies, even amid all the market mayhem. And taking a long-term view is essential.

"I do not focus too much on short-term performance as anything below a year is really background noise as far as I'm concerned," explains Woodford. "Short-term volatility in share prices should not dictate investment decisions. I believe continuing to position my portfolio strategically will enable me to take advantage of new opportunities - including potential bid activity."

As the paper went on to say, Neil Woodford's strategy has certainly placed him well to benefit from the hottest bid in the UK market - utilities giant British Energy has four suitors trying to acquire it. The company makes up around 4% of his portfolio and demonstrates he said that, "banks are still willing to lend against certain projects and the logic of consolidation is still compelling in the utilities sector."

Cautiously Optimistic

Away from the UK equity income sector there are other fund managers who think that shares are looking promising. Another well-known fund manager is Ian McVeigh of Jupiter who looks after the UK portion of the St. James's Place Cautious Managed Fund.

"Whilst no-one currently knows how long or how bad the sub-prime issue will turn out to be, I believe we are about halfway through," says McVeigh. "What has happened is that risk has been re-priced and there has been a contraction of borrowing - both of which have important implications for asset prices as we are seeing.

"Inflation is seen as a problem but it's rear view mirror or lagging indicator and banker's tend to be behind the curve: I don't agree that it's such a major problem in the West although it is in the East.

"Where we are now is that the UK stock market is trading at pretty fair value - headline price-earnings ratios look attractive even if one accepts that earnings are historically high and likely to fall. It's important to remember that equities can and do go up against a backdrop of falling corporate earnings.

"My investment approach is unconstrained - in other words I am happy to take a multi-cap view with no particular bias towards either small or large companies. What I am looking for, amongst other things, is the recovery potential of a company, a catalyst for change that will give the stock a re-rating.

"Within the portfolio I have a small number of high conviction positions, for example I bought mining company Xstrata at £7 with the belief that I would hold until I saw events changing. I have seen other managers trying to trade the stock but I have continued to hold the shares and today they're at £40.

"Fortunately I avoided banks but HSBC looks interesting so I've been adding it to the portfolio - it's in a very fortunate position of having, unlike most of its competitors, excess liquidity, a strong balance sheet and possibly 100% upside.

"Most of the companies listed on the UK market are deriving earnings from outside the UK - in fact two-thirds of the value comes from outside of Britain. Being an international market means I can develop my global growth theme. I own Charter, an engineering company that is doing well exporting to China and there are others like them. Overall I am optimistic that equity risk is now skewed in our favour."

14th April 2008

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