The Week That Was

Posted on: 23 September 2008 by Gareth Hargreaves

From Lehman Brothers to Lloyds TSB and HBoS, Graham Kerner analyses a week of financial frenzy.

Tumultuous, febrile, cataclysmic, completely insane - that was how the media summed up what will probably be one of the most extraordinary weeks in the history of the world's financial markets.

"To hell and back" was probably one of the most succinct headlines from The Times as it summed up events on its front page. So how did it all start?

Black Monday

The scene was set last Monday when it emerged that the US investment bank Lehman Brothers had filed for bankruptcy after failing to find itself a white knight.

Moments earlier, before the markets had opened, Bank of America announced that it was to buy troubled investment giant Merrill Lynch for £27 billion.

The view was that in allowing Lehmans to fail, the US Treasury had taken a huge gamble and that financial markets faced an unprecedented challenge of absorbing the unwinding of a major broker, according to The Financial Times.

As the week progressed, Barclays Bank emerged as a buyer of some of the fallen bank's US investment banking assets, but in London, angry staff were left shocked, as Lehman's 5,000 UK workforce was summarily sent home. The ramifications of the job losses were mulled over in The Financial Times which took the view that this was another blow to a fragile UK economy that is heavily dependent on the financial services sector.

But with the day hardly begun, rumours that insurance giant AIG was in trouble and had appealed to the US Federal Reserve for help, added to the shockwaves rumbling through the financial markets. The company's balance sheet has been savaged by billions of dollars of write downs and credit losses leading to fears that its own credit rating would be downgraded that could in turn lead to a liquidity crisis. In America, insurance regulators attempted to throw the company a $20 billion lifeline by allowing it to access assets from its own subsidiaries to use a loan collateral.

In the meantime investors moved to the sidelines, selling shares and causing major falls on the world's stock markets.

Tortuous Tuesday

It was a day of mixed fortunes in global markets with Wall Street rallying on hopes of a US Government-backed rescue of AIG amid fears that the collapse of one of the world's largest insurers would further destabilise the global financial system. However, despite the turmoil in the markets, the US Federal Reserve kept interest rates unchanged at 2 per cent and equities rose on the news as investors interpreted the decision as signalling that it was poised to rescue AIG.

The story was different in London where shares in the UK bank HBoS came under intense pressure, losing over half their value at one point before rallying. The FSA was forced to reassure investors that the bank would not become the next victim of the turmoil in global markets.

Analysts said that the collapse of Lehman Brothers had made banks wary about lending to each other in the wholesale markets and had made lending rates more expensive as a result.

Following the news that Lehman Brothers had filed for bankruptcy, Mark Evans of THS Partners gave a very frank assessment of events.

"I have to admit for the first time to feeling quite scared, but having said that I am reassured by the sound advice of my late colleague and veteran investor, Nils Taube, who always said, 'When you feel scared, it's a sign you should be buying'."

"We haven't sold anything or indeed been rushing into the market, but rather have been drip-feeding money into the market over recent weeks, buying stocks we have identified as offering good long term value. It's important to remain focused on the fundamentals of owning equities and whilst current events are understandably creating anxiety, I still believe there is value to be had as the crisis eventually subsides, as it ultimately will."

Another fund manager who has been through many difficult times is Andrew Green of GAM who manages funds for St. James's Place.

"The markets are very febrile and being driven by emotion rather than fundamentals so it is difficult to judge whether the worst is over as yet. But most of the poison chalices have been identified - the only others are AIG and HBoS and it is likely these will be resolved soon."

"When the markets are behaving as they are it's important to stick with one's strategy so I haven't been doing anything in response to the latest events which are, of course, quite extraordinary. The fund continues to have a high liquidity position of around 20 per cent and the defensive nature of the portfolio means, for example, that I have not owned banking shares. In recent weeks we've been making some progress and so far my strategy is working, with stocks like Royal Sun Alliance bucking the trend."

"The market does look undervalued - the yield on the stock market exceeds that of the ten-year gilt and this is quite a strong signal, although I am a little wary about banks' earnings going forward and they, of course, account for a significant part of the market's yield. But for now we have to watch and wait to see if the action being taken by the central banking authorities works."

Wednesday Gets Worse

The Financial Times said that panic in the credit markets created a flight to safety not seen since the Second World War, despite news that the Federal Reserve had rescued AIG with an $85 billion bail-out, effectively nationalising America's biggest insurance company. Adding to the considerable strain on global debt markets, the US Government struggled, said The Independent, to reassure traders that the loan would be enough to restore health to the company and the credit derivatives market in which it is a pivotal player. The move by the US Government effectively saw it take an 80 per cent stake in the troubled business.

In London there was more drama in the banking sector as shares in HBoS slumped to an all-time low before news leaked that Lloyds TSB, with the blessing of the UK Government, was planning a takeover of the beleaguered bank. The danger of a run on the bank became very real as people recognised that holding cash is not necessarily as safe as they had previously believed. The merger creates a £30 billion giant with nearly a third of the mortgage and savings market, breaching competition rules, but saving the banking system.

It was no surprise, of course, that shares prices continued to fall in London and elsewhere as investors tried to cope with the news flow and assess the longer-term implications. In Russia, trading on the country's stock exchange was suspended in reaction to the upheavals across global markets.

The potential failure of insurance giant AIG would have had massive ramifications for not just the credit markets, but also the wider market too; a fact that Paul Read of Invesco Perpetual, one of the managers of our Corporate Bond fund knows only too well.

"The decision by the US Treasury to rescue AIG had to happen. The company had to be rescued because of the implications globally. It is good news for the capital markets, although it will take time to understand what impact this has for investors. I see this as an orderly run-down of the business which has good quality assets, but it will be good for the markets generally because AIG's problems have weighed on them for a while."

"Even so, I think current conditions will last for some months yet though. Looking at the recent actions by the authorities, some have been quite profound - the bail-out of Freddie Mac and Fannie Mae, AIG - and will lead to a period of consolidation in financial markets which will ultimately be good for investors."

Tough Action On Thursday

The day started once more with continued volatility in global markets, with fresh rumours circulating about the health of another US investment bank, Morgan Stanley - the only major investment bank, apart from Goldman Sachs, left standing. Morgan Stanley said it was in talks to sell a stake to China Investment Corp, according to The Financial Times, as the firm endeavours to ensure its survival and reverse a slump in investor confidence. However, the sale of such a stake in a blue-chip Wall Street firm to a Chinese statecontrolled entity could cause a political backlash in Washington said the paper.

But as the day wore on it became clear that policymakers were beginning to act in concert to quell the raging storm, as the world's financial system teetered on the abyss.

In London the City watchdog, the FSA, took the drastic step of banning short-selling of financial stocks. Short-sellers sell stock they do not own in the hope of buying them back later at a lower price and have been blamed for driving down the share price of the likes of HBoS.

Earlier on in the day central banks had acted together to offer $180 billion of liquidity to banks outside the US that needed dollars and the move had some success in bringing down overnight borrowing rates that has hit extraordinary levels on Wednesday and brought barometers of systemic stress back from historic highs.

But the real action came towards the end of the day - too late for London which had closed - when rumours circulated on Wall Street that US Treasury Secretary Hank Paulson was about to announce a massive bail-out for the US banking system. Having spent most of the day in the red, American shares rallied swiftly to end the day some 400 points higher after having been down 150 points earlier. As the closing bell rang on Wall Street traders and investors alike had clearly put their hopes on the Bush administration coming to their rescue.

Freaky Friday

The leader in The Daily Telegraph as it described global stock markets' reaction to news that the US authorities, under the stewardship of Hank Paulson, announced a move towards a sweeping programme of Government intervention that would put hundreds of billions of dollars of US taxpayers' money at risk in an effort to quell the credit crisis.

The markets' reaction to the plan to mop-up hundreds of billions of toxic debt into a loan fund - modelled on the Resolution Trust Corporation created to purge bad debts in the savings and loans crisis of the 1980s - could only be described as a roar of approval.

London saw its largest daily gain in its 24-year history with the FTSE100 jumping 8.8 per cent to over 5,300, whilst in New York the S&P 500 index closed up 4 per cent after rising by 4.3 per cent the previous day.

The political negotiations on the rescue plan envisage the most extensive peacetime expansion of the Government's role since the Great Depression and appeared to many, said The Financial Times, to mark the end of an era of deregulation.

Cato Stonex, a colleague of Mark Evans at THS Partners, gave his reaction to the news.

"The Resolution Trust plan, together with the huge injection of liquidity by the central authorities, is very welcome and demonstrates their resolve to solve the current crisis. It is their way of telling the hedge fund community and their ilk, those who have thrived by shorting stocks, that enough is enough because of the serious risks these people were posing to the financial system."

"It is time now for faith and credibility to be restored to the system and I do believe that these actions will succeed and must succeed. I think the current crisis has scared both Wall Street and the City to the point that excessive leverage is no longer on the menu so it's been a wake up call to these people. But it's a healthy process because it means we can go back to investing savers' money in sensible long-term opportunities without having to worry about the madness of speculators, so I'm cheered the authorities have done this now."

"Of course, it will take time for people to believe these actions will stem the crisis and that they will work but it is undoubtedly a good morning!"

The Aftermath

Whilst it is early days yet, many feel in a lighter mood, accepting there is much work to be done in the months ahead, but that a map to recovery has been laid out. Writing in The Times, economist Anatole Kaletsky wrote that, after a breathless week, he was optimistic again and that fears of bank failures and financial panics should soon disappear as the US Treasury takes radical new steps. Kaletsky admitted that he has lurched from optimism to pessimism and back again in recent weeks, but explained why.

Firstly, the rescue of Fannie Mae and Freddie Mac was the first sign of action by the US authorities, but seen by some - short-sellers - as a one way ticket to profit, so to stop this happening, short-selling was banned. Moves by the US to support the banking system and the rescue of HBoS reassured Kaletsky, but he accepted that a slimmed downed financial sector will probably mean a modest slowdown for the rest of the economy.

The UK was likely to see more job losses and falls in house prices but the recession would be mild. He was hopeful too that an outright recession can be avoided in the US if financial stability is quickly restored, the worst of the housing slump appears to be over and consumer confidence is rising.

Elsewhere there were signs that last week's events could prove to be a turning point for the stock market, even if the economic outlook remained difficult. The Financial Times pointed out that the UK stock market last week crossed a technical threshold that is often considered a strong buying signal for the first time in five years. The paper explained that the dividend yield on the FTSE All-Share index has exceeded the yield on a ten-year gilt for the first time since 12th March 2003 - the nadir of the last bear market.

The 'crossover' came as one of the UK's most successful fund managers, Anthony Bolton, who suggested that the worst was almost over for share prices.

"I feel we are entering the final phase of the bear market. It started with a downturn in financial, then consumer cyclicals and the next stage was the industrial companies. The last stage will see commodities affected - I felt that until commodities got broken, the bear market could not end."

Indeed, commodity prices have fallen sharply in recent weeks and amidst the turmoil last week the price of crude oil fell below $100 per barrel for the first time in months and takes some of the heat out of inflationary pressures.

Looking Ahead

With so much turbulence in global markets it would be easy to think that the best place to be is cash, but for experienced professional investors, the type of event we have recently witnessed actually creates opportunities. Richard Oldfield, manages a portfolio for St. James's Place that contains ten of his best ideas, picked globally.

"My own particular approach to stock picking differs in that I don't look at the macro picture when deciding what to invest in. In other words, I concentrate on the fundamentals of a business, looking at the balance sheet, earnings outlook and whether the company's share price offers good value. Obviously, current events are relevant because they impact on these valuations, but my strategy is not driven by them - I have a very diversified approach."

"Actually, at present there is no shortage of good stocks that I would happily own but I have just ten which are diverse both by geography and by sector."

"In Japan I own Canon and Orix - a leasing business which trades cheaply yielding 3.5 per cent, which is high by Japanese standards. The Japanese market is ridiculously cheap I think, trading at levels not seen for many years - and cheap on an international basis too which is significant, so I see great opportunity here.

"In the US I own what I call my 'steady Eddie' - Johnson & Johnson which has delivered 70 years of unbroken earnings growth."

"DR Horton is America's largest home-builder and well positioned for recovery."

"I bought RBS at 165p which I think will do better than most think; Barrick Gold has a place because it is effectively an insurance policy in the current environment but also cheap relative to other commodities.

"I've recently added British Land which, despite writing-down its assets, still trades at a 37 per cent discount to its net asset value and is a sector stalwart with blue-chip tenants and low levels of borrowing."

"Vivendi is a telecom conglomerate and in the energy sector I've bought Conoco, whose current share price assumes positive earnings with oil at just $70 per barrel."

"Even though I think we are in a period of stagflation with the immediate outlook a bit murky, I am very positive about the longer-term because we are witnessing some of the lowest share valuations seen for some 25 years. There is an enormous cash mountain out there which is yielding little more than the stock market, but has no growth prospects and ultimately some of this will come into the market."

As always, it is difficult to call whether this signals the bottom of the market but historically, the best investment opportunities often arise at the height of pessimism. A fact pointed out by Anthony Bolton writing in the weekend Financial Times.

"Conditions do indeed look grim at the moment. It is often when things look worst that the best opportunities emerge. I've always been a contrarian investor - running against the pack. It is at times like this that we all have to be contrarians."

The next few weeks and months may continue to bring volatility, but hopefully, at a reduced level. For those with a 3 to 5 year view, drip-feeding money into the market may prove the best investment strategy.

22nd September 2008

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