Time to pay
Market commentators are fond of historical parallels. As the UK consumer is finally waking up to the fact that one day the bill really does fall due, economists and asset managers are torn between likening this downturn to that of the early 1990s – when house prices tumbled – and the 1970s – when inflation ran amok. I’ll let you know when we get a consensus.
John Beck, co-director of international bonds at Franklin Templeton Fixed Income Group, says that August 2007’s credit crunch is only now hitting the wider economy, and despite the measures that are being put in place to help UK banks over the hump, further pain is likely.
Last week’s breakfast meeting at Downing Street quashed hopes of a quick fix, with the Bank of England offering its collateral swap facility only at a significant haircut, whilst the capital risk will remain with the banks rather than being shouldered by the groaning taxpayer.
No such thing as a free breakfast
Under the terms of the special liquidity scheme, banks can swap high quality mortgage-backed and other securities for UK gilts and then use these bonds as collateral for loans from other banks. But the banks need to provide the Bank of England with assets of much greater value than the Treasury Bills they receive. And if the value of the assets falls, or are downgraded, the banks will need to stump up the difference, replace them with better assets, or return some of the Treasury Bills. “This is the most expensive breakfast those bankers have ever had,” says Beck.
But as Howard Archer, an economist at Global Insight warns, for the scheme to have the maximum beneficial impact, several other developments need to happen in tandem. These include greater transparency from banks on their losses and exposures to the sub-prime crisis; steps by the banks to improve their balance sheets, such as the rights issues by RBS; and a commitment by banks to quickly reflect any fall in market interest rates in their products and loan rates to customers.
Beck believes the RBS rights issue will be the first of several capital-raising exercises. “With the banks we are potentially at a turning point similar to what we saw with the telcos in 2003, when their debt was downgraded. There was vast excess capacity in the telecoms industry and the bond markets had been paying for it. Now I think we are getting to the point where the bond markets and the regulators have got fed up with the banks, and will only let them raise capital at penal rates.”
Although he sees the move towards raising equity capital as good news for debt-holders, he doesn’t expect an improvement in the economy for some time. “Debt spreads are still very wide for banks and stock prices haven’t recovered. Now we are seeing the consumer impact. The first round was the write-offs from securitisation. Now the write-offs on loans to consumers are coming.”
You are now entering a recession – please take care
Not surprisingly, UK equity managers are gloomy. “The economic data has been much worse than expected and the credit crunch has been deeper and more long lasting than we expected six months ago,” says F&C’s Ted Scott, manager of the UK Growth & Income Fund. “My view now is that the UK will have a recession, whereas six months ago there was a chance that we might avert a recession or it would be a pretty shallow one.”
But with the financial system still frozen and banks reluctant to lend, the housing market is beginning to implode under the pressure of unsustainable price rises and higher interest rates. “In the US, house prices have fallen 30% or so and it’s quite conceivable that in the UK we will see a fall of over 20% peak to trough,” Scott argues.
With home-owners struggling to meet their mortgage payments, other spending is expected to dry up. “They will be cutting back quite severely, and that’s going to have a big effect on the economy.” And Scott believes the recession could be more severe if unemployment rises from its current relatively low level of one million.
“Back in the last recession it got up to about three million, so if we start to get a lot of redundancies that would make it worse,” he says. “At the moment the problems are confined to the financial sector but if it’s a wider economic problem we could find that lay offs increase sharply.” With the credit crunch still ongoing, he draws a comparison with the 1970s and the UK’s secondary banking crisis, which took place against a backdrop of rising inflation and oil prices, pay freezes, and the three-day week.
Mark Lovett, co-CIO of European equities at RCM, is also pessimistic, but adds that RCM has been quite negative on the UK consumer since the beginning of 2007. “We’ve been concerned about the ongoing pressures on disposable income and the fact that the savings rate is so low, and how that will affect consumer spending.”
He sees the UK growing at below trend for two or three years, with a sharp V-shaped recovery in 2009 or 2010. “We don’t think this is something that will be resolved quickly, and below trend growth will probably be quite healthy in terms of unwinding some of the consumer debt and the low savings rates that have been so prevalent.”
Bear-market rallies
Ironically the market has roared ahead in the last month and is up nearly 10%, but Mark Lyttleton, manager of Merrill Lynch/BlackRock’s UK Dynamic Fund, remains wary. “People are saying that the worst has happened and that this is reflected in the valuations already. And now they see some solutions to the credit crunch. But it’s not just about getting the banks to lend to each other, it’s about all the losses they have made, and actually announcing them,” he says.
“If you’re prepared to take a two-to-three year view, there is probably some value in some of the bombed-out UK discretionary names. The problem is the news flow is going to get a lot worse before it gets better. So you have to decide how much of that is in the price and whether you can afford to wait. There will be some speculative rallies when some of these sectors will bounce back up, but I’m playing it quite cautiously.”
And although the markets have recovered in the last fortnight, and the VIX has been less choppy, Lovett does not believe that this reflects a change in confidence levels. “The average market participant is still very nervous because of the lack of visibility about the economic environment, and I expect volatility to remain high through the rest of 2008,” he says.
If you want to read more about how UK equity managers are positioning their portfolios to weather the slowdown in consumer spending, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=39125
conceptualizer said,
April 23, 2008 at 2:34 pm
People love to own things and getting them without first doing the work to earn the cost of them is increasingly easy, even for the least financially endowed or savvy. This is possible because others can profit from that eagerness. I would even go as far as to say this is a new era, where debt for non-essentials became nearly pervasive by choice around the end of the 20th century or the start of the 21st century. At least, that is the case in the most complex economies.
Putting the current financial blip aside for the moment, do you expect this trend to continue? If you do, will this not lead to strong consolidation of lenders as they come under increasing pressure from competition to offer tighter margins on larger volumes of increasingly commoditised debt? That seems to me the pattern for other commodities. That would create hugely powerful global lenders which could put downward pressure on lending rates to encourage greater usage of debt. Eventually it would become almost free and acceptable to have from cradle to grave. Perhaps I am extrapolating too far here, but supposing it did happen; would it not be an enormously stabilising influence as the lenders would inevitably be very influential in every economy. Their influence could even be the glue that finally prevents war. We can already see significant interdependence between the worlds largest financial centres and their influence on government policy.