The Worst May Be Over For Markets

Posted on: 12 May 2008 by Gareth Hargreaves

Graham Kerner picks out some of the key financial and economic issues of the last week.

Oil prices hit another record high, raising concerns about inflation. Consequently investors moved to the sidelines leaving most - not the UK - stock markets 1 to 2 per cent lower on the week.

Overall though investor appetite for equities has improved in recent weeks as optimism that the worst of the credit crunch is over prevails.

Investors should resist the temptation to follow investment fashions and taking short-term views on investing. Buy-and-hold strategies have proven far more successful.

A Sticky Situation

A year ago it would have seemed inconceivable that the price of a barrel of oil would cost $100, but last week the price of crude continued its seemingly inexorable rise, hitting a record high of $126 - a gain of around 8 per cent on the week. Needless to say, traders were speculating that the price could move even higher, with a warning from Goldman Sachs that oil prices could spike to $200 a barrel within two years, enough to send the bears running for cover, according to The Financial Times.

But it was not just speculation that fuelled the commodity - continuing supply problems in Nigeria have hit global supplies and demand from the likes of China and India remains high. The Times said that an announcement by the president of Brazil that the country would join the oil cartel Opec exacerbated the problem - the country is set to become a major producer following a series of oil discoveries, including the Carioca field which could be the largest find in the world for thirty years. Help from oil producers has not been forthcoming and last week Opec brushed aside American calls for a production increase, saying the market was well supplied.

Oil is not the only commodity to keep setting new price records. Last week the cost of a bushel of corn also hit a record high of $6.27 - up 75 per cent in the past year - with some analysts warning that it could rise to $7 a bushel, indirectly raising the cost of meat and dairy products. The price rises underline market fears about inflation which has been on an upward trend for some while now and is causing considerable angst amongst central bankers.

A further twist evolved last week, according to The Financial Times, in terms of the US dollar and its relationship with oil prices which have until recently tended to move higher as the dollar weakened. But with the greenback broadly flat on the week this correlation has faded leaving currency market traders scratching their heads. Indeed, the dollar has surprised traders on the upside - a point made by economist Liam Halligan in The Sunday Telegraph.

After slumping to an all-time low against the euro and twelve-year lows against the yen only a month ago, the US currency has strengthened, with the markets talking about a 'turning point'. A plummeting dollar is in no-one's interests Halligan argued, as inflation would rise amid soaring import costs, forcing the Federal Reserve to raise interest rates.

Washington is likely to be content with the current situation, but the currency's recovery is more about the weakness of the eurozone than the robustness of the US. A recent slew of poor data has highlighted the fact that the region's economic health is failing, with falling retail sales and contracting factory orders in Germany - the eurozone's powerhouse. The view is that the European Central Bank will be forced to cut interest rates thus making the dollar more attractive.

In the meantime, America likes events - the weak dollar is boosting exports and encourages foreign investment and so helping the US out of its economic hole.

Equities On Hold

Against this backdrop it was unsurprising that most of the major equity markets paused for breath after their rally over recent weeks as investors took a rest and moved to the sidelines.

On Wall Street, concerns about the health of the financial sector were revived and similarly, in Europe, investment bank UBS was a loser, but in London the market held its own. Buoyed by bid activity, the main FTSE100 index ended little changed on the week, consolidating its position at the 6,200 level - less than 10 per cent from its high last year - even though the Bank of England left base rates on hold at 5 per cent.

In the Far East, Asian markets also fell as traders reacted to soaring oil prices and fears of further monetary tightening in China - the Tokyo market shed 400 points and in Hong Kong, the Hang Seng index retreated 5 per cent on the week.

The bigger picture though looks promising, as The Financial Times commented, saying investors are boldly returning to the battered sectors of the equity markets, believing that the darkest days of the market downturn are over. The falling price of gold, a short-lived rally in US government bond yields and news that US job losses were fewer than expected have acted as catalysts for renewed investor optimism.

In America, comments by Treasury Secretary Hank Paulson implied the worst of the credit crisis was over when he said, "In terms of the capital markets, I believe we are closer to the end than the beginning." So gradually, institutional fund managers are picking up stocks they believe are over-sold and although the timing will never be perfect, as the paper noted, providing investors are taking a long-term view it should come right.

A point made last week by investment sage Warren Buffet who, when asked about where he thought the stock market was heading replied, "I haven't the faintest idea where the stock market will be next week, next month or next year. We are looking for businesses that are properly priced. If you are right about that, the stock prices will take care of themselves."

Crumbling Foundations?

Whilst the credit crisis might be past its worse, there is clearly still pain being felt in the economy - especially in the housing market as people were reminded last week.

The Independent reported that repossessions are set to soar to their highest for 17 years as the effects of the credit squeeze push court orders from banks and building societies to record highs. Apparently the number of home repossession orders climbed by 6.3 per cent in the first quarter of this year to around 25,000, although the actual number of repossessions remains below this number because lenders usually find a way to resolve the debt problems with homeowners.

The Financial Times also reported that its own house price index showed back-to-back monthly price falls - confirming other recent surveys.

In the house-building sector the gloom enveloping developers thickened last week as Bovis joined the list of builders warning of slumping sales - the company blamed a sharp deterioration in the wider housing market with first-time buyers finding it difficult to raise mortgages. However, with the sector in difficulty and share prices devastated some investors see this as an opportunity.

"Whilst we have avoided house-building stocks for 18 months the recent price falls are probably overdone now," commented John Hodson of THS Partners who manage funds for St. James's Place. "There are some well run businesses out there whose share prices are trading at significant discounts to their net asset values and we are keeping a close eye on the sector. Having plenty of liquidity in the portfolio means we can buy these types of distressed stocks at very low prices."

So Chic

Fashions are not just the preserve of the Paris catwalks - investors succumb to similar ideas in the investment world as The Times sensibly reminded its readers. In the late 1990s, technology funds were the must-have item and investors poured billions into them, only to see their value collapse by around 90% after the dotcom bubble burst in 2000. There are many others too of course, but instead of buying low and selling high, many investors do just the opposite because of a preoccupation with short-term performance. "Investors all too often try to chase yesterday's winners but then flee when the going gets rough," commented Morningstar, the fund research group.

The Sunday Times struck a similar chord, pointing out that many 'safe' funds have lost money during recent times, specifically targeting the likes of 130/30 funds where managers follow strategies that should help protect capital during falling equity markets. But as the paper said, all but one of the eight funds launched last year under-performed their benchmarks, with most losing money. There are some who argue that commodities are set for a fall too following a rush of investors into this sector. Either way, investors can improve returns by finding a good fund manager and adopt a buy-and-hold strategy and not move in and out of funds.

No Change

One investor who is renowned for not following investment fashions - he avoided the dotcom bubble - is Neil Woodford of Invesco Perpetual. Probably the UK's most successful and respected fund manager, Neil also manages funds for St. James's Place. The stock market volatility of recent months as a result of the credit crunch finds him unfazed by events.

"I have been pessimistic for a long time about the economic outlook and so I have been expecting more difficult investment conditions. In anticipation my portfolios have been defensively positioned to protect investors' capital so as we stand today my views are unchanged which means I continue to buy, at what I believe are very reasonable prices, companies with strong balance sheets, the ability to grow earnings and pay increased dividends - even in an economic slowdown.

"We are currently witnessing the knock-on effect from the credit crisis in the form of a significant negative influence on the US and UK economies, which is likely to continue for some time. I think there would have been a slowdown in any event via the housing market, which had become very overvalued. The confluence of events means the outlook for global growth is weaker than consensus and this includes Europe. The macro-economic picture has worsened since the start of the year so I think recession is inevitable and of particular concern is the consumer economy which has been buoyant until now. A fall in house prices over the next two years followed by flat growth will bring about a new attitude to debt so I think property will be a pretty disappointing investment for five years. We are now returning to a more normal environment with consumers taking a more conservative view of their finances, which is good thing.

"I have maintained my overweight positions in those sectors not exposed to consumer cyclicality - such as retailers - and there are plenty to choose from even during a slowing economy. So I own the likes of GlaxoSmithKline, which has been deeply out of favour, utilities and of course energy stocks like BG and British Energy. The latter is subject to takeover and I think there will be further consolidation in the sector, which will help me.

Banks may look cheap and whilst I may sound like a stuck record vis-à-vis my negativity on the sector, I am not persuaded to the argument that they are good value.

My ambition continues to be to deliver high single figure returns - the first part of 2008 has been difficult but I remain confident, taking a medium term view, I can continue to achieve this for my investors."

12th May 2008

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