Forever Blowing Bubbles
This time it’s different – the plangent refrain of the investor suffocating in a bubble. Ah, what bliss it is to recall the golden days of the dotcom era, when we thought the mini-scooter-driven party would never end. We would all be commuting to work via the internet and downloading our memories into cyberspace in a kind of Neuromancer-meets-Facebook “mash up”.
Now we look back and scoff at the delusions of our younger selves. What on earth were we thinking? Boy, we were really stupid 10 years ago! We forgot to ask important questions like: What does this company do? And: How will it make money? Thank goodness the commodities super-cycle is nothing like that.
And just why is it so different? Because China and India are industrialising like crazy, of course! Who could pass up that opportunity? Hmm, well let’s just run a slide rule over that shall we?
Tony Dalwood, head of public equities at SVG Investment Managers, believes that mining stocks and other natural resources plays, which have run up on the back of the commodities boom, are heading for a fall. “Value investing has underperformed because commodity stocks like the miners have got ahead,” he says. “The market is focusing on cyclical peak earnings, but miners are heading for a problem when returns normalise.”
Panic and crisis
Adam Steiner, head of research, public equities, at SVG adds: “The investment time horizon of hedge funds and traders is microscopic compared to pension funds, and the markets are now very momentum driven. In moments of panic and crisis no one is using valuation to pick stocks – they just churn their portfolios to try and keep up to date. They don’t want to be underperforming the market at the end of the quarter.”
He argues that resources companies are “grotesquely overvalued” – mining is a cyclical industry and is generating the highest returns it ever has, but as costs go up and more capacity comes on stream this won’t continue. “Whenever you have a bubble there is always an argument that this time it is different,” he says. “People are pointing to the impact of China, but the increase in the oil price is not completely accounted for by that. To pretend the demand for resources is in no way influenced by the global economic cycle is crazy. If oil goes to $200 a barrel then the average US driver has to spend 10 to 20 percent of their income on petrol. So you have to ask – if everyone in China owns a car, how will they afford to drive it around? High commodity prices in themselves slow global growth.”
He adds that the population of China is only three and a half times that of the US, and the majority are peasants in the north and west. So the Chinese economy will only become two or three times bigger than that of the US and it will take a long time to get there. “You also have to keep in mind that a lot of China’s growth has been financed by US debt.” That is, consumers withdrawing equity against their homes to keep spending – something they are unlikely to be doing much of in the foreseeable future.
The commodity gurus argue that prices are supported by years of under-investment, which has created a pinch point – miners can’t get the stuff out of the ground fast enough, so prices keep increasing. But when new capacities come on stream, shouldn’t prices correct to more realistic levels, especially if the US is in the doldrums? So investors have to ask themselves: How far do we want to ride this boom? You can bet the chartists are hunkered down over their models right now trying to call the peak.
Buy-to-let blow up
Steiner is also worried about the horrors that may lie ahead for the UK, especially if the buy-to-let boom turns out to be the UK’s very own sub-prime meltdown. “The banks have only written down their lending impacted by the US so far, not their UK lending losses,” he argues. “That will come if we have a nasty house price plunge. For the last few years there has been a very strong tailwind that has helped retailers, banks and property, but that has now gone into reverse, and it is likely to be a headwind for another three to five years. The issue will become – how are banks going to make money now? The ratings will recover but the earnings won’t.”
SVG takes a contrarian approach and is focused on companies not at the peak of the cycle – particularly, telecoms, pharmaceuticals, software and media companies. Steiner says that pharma stocks are interesting as they are “off the scale cheap” – some 40 percent below their 20 year average. “All the arguments for pharma – such as the ageing demographics – remain intact, but they have been hit by the FDA tightening up its approvals process and the market is fretting over near-term fears.”
He adds that media is “mind-blowingly cheap” because of fears that if the economy does turn down, media will do badly. SVG is focusing on business-to-business companies such as DMGT and the WPP agency, which is more diversified, and therefore less cyclical than people seem to think. “This is the exact inverse of 1998 to 2001,” he argues.
It’s an interesting idea – that TMT will ride again after a speculative bubble in commodities goes pop. M&A activity in the small and mid-cap telecoms and software sectors has been brisk in the last couple of years, with strong private equity interest. “A lot of small and mid-cap deals are happening and they have raised a decent amount of money,” says Steiner. Telecoms has now re-rated a little, but SVG believes there is further to go. Perhaps it’s time to dust off that mini-scooter and drive back into the TMT market again.
If you want to read more about developments in the TMT sector, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=42257
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
Recess is over
The Easter break may have given the market time to reflect, but it would be unwise to expect a sudden improvement in fortunes. Bob Doll, CIO for global equities at BlackRock, has pointed out that a series of explosive daily moves is the norm for a bear phase to end, whilst high profile financial failures, such as that of Bear Stearns, are often coincident with market bottoms – think of Savings & Loans associations in 1989, LTCM in 1998 and Enron in 2002.
But Doll has also warned investors that the lack of confidence in the banking system has developed its own inertia, and this is likely to persist until policy intervention becomes significant enough to arrest the trend.
Sadly, last week events seemed to be threatening to spiral even further out of control, as rumours circulated about various US investment banks, before the UK’s HBOS came under fire. “What is genuinely terrifying for financial markets is the power of market rumour,” said Neil Dwane, CIO Europe at RCM. “The most important thing here is the speed with which this all happened…You can get talked into going bust in these financial markets.”
Regulators may suspect mischief-making behind the rumour mill, but the underlying fear that haunts the markets is of a chain reaction of defaults setting in that would see the whole banking system go down, like in the 1930s. “There’s a sense that investors have become more risk averse, and there’s a spiralling effect with that so if one set of investors gets more risk averse the price of the asset falls and that contributes to the general sense of pessimism,” says Simon Ward, chief economist at New Star Asset Management.
The credit markets are not functioning particularly well – liquidity is pretty close to zero, and in the bank loan market there is a high mismatch of supply and demand due to deleveraging by hedge funds and the unwinding of SIVs and conduits. “That is putting out prices to levels that have nothing to do with the fundamentals as we are not seeing a lot of defaults,” says James Gledhill, head of fixed income at New Star Asset Management. For example, high yield debt is discounting a default peak of 10 pct, even though defaults are only at 1 pct at present.
And even though the Fed has been cutting significantly for some time, the market’s expectations of further rate cuts mean that this is already factored into T-bills: “They are way ahead of where the Fed is, so rate cuts are now just psychological.”
Inflationary impact
BlackRock’s Doll agrees that as equity markets won’t rally until the credit markets stabilise, this will require a sense that the Fed is finally getting ahead of the curve.
But the Fed’s rate cutting is making some economists, like Ward, nervous about the impact on inflation. “The rise in energy prices is one of the reasons why the US consumer is under so much pressure,” he says. “I think they should have eased policy more gradually. They should have waited for some weakness in commodity prices and inflationary pressures more generally, and at that point they could have cut more aggressively.”
Indeed, there has been an understandable reticence from the Bank of England to cut as aggressively as the Fed as it has to focus on its inflation targets, whereas the Federal Reserve also has a mandate to consider GDP growth. “Inflation is just about to spike up because of rising commodity prices, but once we are past the oil spike we may see more aggressive rate cuts from the Bank of England,” says Toby Thompson, manager of the New Star Higher Income Fund.
He suggests that equity markets seem to be expecting an early 1990s-style recession, but he doesn’t see this in the UK, arguing that different factors are at work this time round. “In the 1990s, we saw negative equity fuelled by heavy falls in house prices and significant write offs in bank lending. There were also significant commercial property write offs. It looks like the markets are expecting this again, and therefore see a big hit to banks’ earning capacity,” he says.
Debt blow up
However, he points to a big difference in the rate of debt expansion this time around as borrowings in real terms have increased by only 5 pct per annum, whereas in the run up to the 1990s recession they were up by 13 pct per annum. The biggest factor in predicting whether this will blow up in the banks’ faces is how much has been piled on at the top of the cycle, and for some analysts, the size of the buy-to-let market in the UK is a key concern.
But Thompson also argues that in the 1990s, the UK house-builder market was more fragmented, and house-builders had greater levels of debt. “So they had to sell as many houses as they could to generate cash and worried less about the prices.” Now the top 10 house-builders have control of half the market and are not as significantly indebted. They have also realised that their land holdings are of value, so they prefer to reduce the numbers of houses they build if the market is soft rather than waste that value. “In the 1990s there was a greater degree of speculative build, and house-builders continued to build when the market softened,” Thompson says.
However, RCM’s Dwane strikes a more sober note: “We have to remember that in parts of Europe, particularly the UK, the biggest growth in jobs has probably been in finance and housing related industries and we need to remember that many individuals may well lose their financial firepower over the next few years.”
If you want to read more economists’ responses to last week’s interventions by the Federal Reserve, please go to:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=37388
and:
http://www.thomsonimnews.com/story.asp?sectioncode=30&storycode=37485
Pass the candles please, it’s dark in here
It was Dr Marc Faber who first raised fears of a return to a stagflationary era, not unlike the dark days of the 1970s. Faber is often accused of being too negative, but last week Bank of England governor Mervyn King also seemed to be hinting this was a real danger for the UK.
So should we prepare for a return to mass unemployment, high inflation and hideous wallpaper? Are frequent power cuts just a bitter pay dispute away? It seems unlikely, not least because of the rampant privatisation of the 1980s and the erosion of trade union membership, but there is a recognition that the UK is facing a number of knotty problems, giving the Bank of England a choice between two evils.
Economists have criticised the government for running up a huge public sector deficit, but having been elected on a platform of investment in health and education, one can hardly be surprised. The problem is how to tackle inflation and slowing growth when the fiscal levers are likely to be out of bounds.
This week Jim Wood-Smith, head of research at Williams de Broe raised the spectre of public sector unrest as the government struggled to hold the line against wage increases. With the individual’s personal inflation experience running ahead of the CPI, the swollen public sector is likely to become increasingly pugnacious.
Meanwhile, Tim Drayson, senior economist at ABN Amro, says that the Bank of England needs to see inflation expectations come down before it can reduce interest rates. This suggests that a great deal of pain lies ahead for the UK consumer, who has been spending on tick for the last 10 years.
“Inflation needs to be squeezed out by weaker growth,” he says. “But the UK is running a large current account deficit and the pound is still overvalued.” If the pound falls sharply, as Mervyn King has hinted should be allowed to happen – this would be more inflationary than in the US, as it would make the UK’s imports more expensive. Cue further grumbling from workers and a fresh round of pay disputes. “We need a significant slow down in growth to sort this out,” Drayson says.
He thought the next few years would be more like the 1970s than the 1990s, but stopped short of mass industrial unrest and rubbish piling up in the streets: “It won’t be as bad as that.” However, there are worrying clouds on the horizon – the foreign capital flows that helped offset the UK’s mighty trade deficit may dry up if the economy starts to look wobbly and the pound is allowed to devalue.
And with the financial services sector heading into what is likely to be a tumultuous reporting season, one cannot expect the City to balance the scales. Instead, the UK’s anaemic manufacturing base may have to start taking up the slack.
In the US, the picture is much less gloomy, despite weeks of recession-mongering from determined pessimists. A stimulating fiscal package worth 150 bln usd is expected to arrive in a timely manner, and it is, after all, an election year. Meanwhile the Fed is expected to continue cutting away like crazy in an attempt to stave off disaster.
As a result, Drayson says that inflation will remain an issue due to inflationary pressure from overseas and the fact that the labour market is relatively tight. “Wage growth hasn’t declined but productivity has slowed and that is putting pressures on margins.” He thought that companies will absorb this until 2009 but then they will start to increase costs. “So the Fed will need to reverse direction pretty quickly into the upswing and raise rates.”
You can read more about the possible return to 1970s-style public sector wage disputes and the problems of persistent inflation at:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=34940
Fed still taking fire
Right now it seems like Federal Reserve chairman Ben Bernanke is damned whatever he does. Having resisted Wall Street’s cries for help with only three rate cuts since September, the Fed was arguably bounced into an inter-meeting rate cut this week by Monday’s widespread sell off.
But with the US markets closed on Monday, the selling continued on Tuesday, and economists have been largely unimpressed by the Fed’s move. The subsequent announcement of the discovery of rogue trading at SocGen simply added to the excitement.
New Star’s economist Simon Ward has been particularly critical of the Fed’s decision to cut rates by 75 basis points, arguing that it is far from clear that the economy – as opposed to Wall Street – requires such a dramatic stimulus.
“Available evidence suggests GDP expanded in the fourth quarter,” he commented. “Real interest rates were not high before [Tuesday]’s action and the Fed did not feel the need to cut by more than 50 basis points in a single move in the last two recessions.”
He also pointed out that cutting rates nine days before a scheduled policy meeting had created the impression that the Fed had been panicked into action by global equity market falls. “Investors will now expect further reductions if equities continue to weaken, regardless of the wider economic context,” he said.
But Bob Baur, global head of trading at Principal Global Investors, said that the Fed was worried about small and medium-sized US companies being hurt by credit tightening by the banks, which would transform a financial markets crisis into a real economy crisis.
“There is no question that the Fed needed to lower interest rates,” he said. “Although the problems are in the financial markets, there has been a crisis of intermediation and banks’ balance sheets are full of risky assets. The Fed wants to make sure that the reduced availability of credit doesn’t hurt ordinary US businesses, and to generate a steeper yield curve.”
Baur said that he was still in the optimistic camp over the US economy, although he accepted that the first and second quarters would be weak. “But the jobless claims are still pretty positive, there is more transparency now in the market with regard to write downs and the sovereign wealth funds are helping to rebuild.”
You can read more initial reactions to the Fed’s rate cut here:http://www.thomsonimnews.com/story.asp?sectioncode=3&storycode=34560
Into The Woods
July 11, 2008 at 1:08 pm (Macroeconomic commentary, UK equity markets) (banks, Bear market, Commodities, energy, financials, Japan equities, mining, monolines, UK equities)
Careful there! Tread quietly! We are now in official bear territory. Who knows what dangers lurk in these woods?
Yes, the FTSE finally succumbed to the inevitable and crashed through the technical bear barrier this week, following the S&P 500’s ignominious tumble into the badlands earlier this month. On Tuesday the FTSE All-Share fell 20% off its October high of 3,467, whilst this morning the FTSE 100 ventured into bear territory by crashing to 5,333.9, well below the 5,385 bear threshold.
“The news that we have officially entered a bear market comes as no surprise to many investors whose shareholdings have halved in value,” said Angus Campbell, head of sales at Capital Spreads, on Tuesday. “The 20% rule simply confirms what we have long suspected since the beginning of the year – we are well and truly in the grip of a grizzly bear market.”
Manoj Ladwa, a senior trader from TradIndex, said that financial stocks, including RBS and HBOS, had fallen further in response to losses in New York, while house-builders had had another bad morning following a predictably weak trading update from Persimmon. “Mining stocks, which have been a mainstay of the index this year, started to weaken, as analysts lose faith in BHP Billiton’s takeover of Rio Tinto happening any time soon.”
Danger – loose bears
Campbell said that it is a clear danger signal when there is a 100 point rally in a market that is trending lower, followed by a large sell-off to test new lows. “That is exactly what we have seen [this week] with financial stocks yet again leading the way. The outlook for pretty much every stock though is truly dire at the moment and if it was not for the energy and mining sectors keeping us afloat, we would have been testing the 5,000 level months ago.”
He added that if investors now pull out of the energy and mining sectors, it is anyone’s guess where global indices will bottom out. The FTSE 100 currently contains 10 mining companies, and seven oil and gas companies. By market cap, there are four mining, and three oil and gas stocks in the top 10 alone, and these companies collectively account for 50% of the FTSE 100’s total market cap. This is creating some concern amongst the trackers, which are now heavily exposed to what tend to be very cyclical industries.
Meanwhile, the outlook for financials worsens day by day. As the economy grinds to a halt, credit defaults are finally starting to come through, threatening to turn what was a liquidity crisis into a solvency crisis – witness Bradford & Bingley’s increasingly desperate attempts to raise cash. All those blank cheques written by merry banks in the consumer spending boom are now falling due. The UK banks are staring into a black hole of buy-to-let mortgages and worthless credit card debt.
This is reflected starkly by the sector’s performance since the credit crunch began. According to Bert Veldman, senior investment manager, global equity, at ING Investment Management, share prices of financials have dropped by an average of 43 percent since the peak in April 2007. And in the second quarter, global financial equities fell by an average of 12 percent.
Eaten by bears
House-builders are also feeling the pinch, with Capital Economics now predicting a 15 percent fall in UK house prices this year, and a fall of 35 percent over three years. Not surprisingly, house-builders have received a thorough mauling by the bears and are desperately trying to raise capital.
Back at sub-prime’s ground zero, the investment banks are still announcing new write-downs following the long-anticipated monolines downgrades last month. After many warnings, Moody’s finally downgraded Ambac and MBIA – the former by three notches and the latter by five notches. S&P had already downgraded both, suggesting that we will see further fire sales by those investors and conduits who can only hold Triple A-rated securities. Investment banks must also increase their risk-weighted capital to offset these downgrades.
For example, Merrill Lynch holds some $18 billion in collateralised debt obligations and asset-backed securities, of which the majority is insured via monolines. Now that these insurers have been downgraded, the risk for Merrill Lynch has increased. The worry is that this will lead to fresh, substantial write-offs and that banks will be forced to liquidate positions, says Caspar van Grafhorst, head of investment grade credits at ING Investment Management. The market is expecting Merrill to write off about $5 billion for the second quarter.
But Guy de Blonay, manager of the New Star Global Financials Fund, says that the key issue for investment banks is not necessarily whether more write-downs will be revealed but whether they can write new business over the next few years. “There has been a fundamental shift in institutions’ desire to embrace risk. Some profitable business lines may, therefore, be closed for months and perhaps years,” he says.
The worsening economic outlook does not rule out the possibility of bear market rallies, however, and this morning the FTSE 100 obliged with a rebound. This followed reports that the US government was mulling a bail out of its hapless Fannie Mae and Freddie Mac mortgage agencies, which Lehman says will have to write off another $75 billion.
This rally was short-lived, however, as the market then charged headlong into bear territory, perhaps after realising that the fundamentals in the UK hadn’t changed. The question now is whether the combined strength of energy and miners will be able to prevent the FTSE falling further. State Street’s latest fund flows note reported that institutional investors are becoming increasingly sceptical about the commodities boom, with selling already underway in the materials sector.
Bear traps
Joost van Leenders of Fortis Investments points out that bear markets usually end with a final sharp fall as the last bulls capitulate. The average decline during bear markets after recessions is 28 percent, but this includes some very large drops, such as the 50 percent fall after 2001. “These large drops started with overvalued equity markets, which was not the case this time,” he adds. However, earnings have been high, and have only just fallen back to trend. He also believes that economic and profit forecasts for the second half of 2008 look unrealistically high.
Fortis is now adding to Japanese equities – still leading the field as the least loved market around – followed by US and emerging market equities. “We have not suddenly become Japan optimists but we think that a lot of the bad news is priced in,” Leenders says. Certainly the Japanese economy is looking in better shape than the UK’s for once. And those bulls have got to find somewhere else to chew grass, right?
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