One of the mysteries of recent weeks is why equity markets have continued to forge ahead, despite the setback in the credit markets. Perhaps that is changing after a rocky day for shares on Tuesday. But as I write, all the major markets stand higher than a few weeks back, when the collapse of two Bear Stearns hedge funds triggered this latest dose of jitters. That’s puzzling for several reasons.
First, financial theory suggests that when interest rates rise, share prices should fall. If investors can get a higher return on “risk-free” assets, such as government bonds, they should get a better return on shares too. For that to happen, shares should fall. Over the last few weeks, the yield on the benchmark US ten-year Treasury has risen to over 5%, having been as low as 4.5% a few months ago.
Second, private-equity firms are finding it harder to finance deals – and since private-equity bid speculation has been a factor in pushing up share prices, that should have a knock-on effect. In the last few weeks, we’ve seen the market push back on a string of deals, such as the mega-loan needed to finance the takeover of Boots. Meanwhile, markets are demanding lower leverage and more restrictive covenants on deals, reducing the amount private equity can pay.
Third, investment banks are reining in loans to hedge funds. In an effort to secure a slice of the lucrative “prime brokerage” market – providing services to hedge funds, such as helping them raise capital and looking after their investments – some banks have been willing to lend funds up to 90% of the value of their portfolio. Now many are pulling back, funds must put up more capital themselves. The risk is that in difficult markets, hedge funds will opt to sell their most liquid assets to raise cash, rather than their riskiest investments, since they are more likely to sell at a fair price. Often the most liquid assets will be shares.
So why aren’t shares falling? Well, for a start equity investors may be taking a more sanguine view of the credit-market jitters. After all, deals are still going ahead. Credit markets may be tightening lending criteria, but they are relaxed by historic standards. The covenants being put back into loans are only those that were very recently removed and leverage levels remain high. What’s more, corporate balance sheets look robust, profit growth is strong and share valuations are reasonable – both in historic terms and against other asset classes. Investors are sitting on cash piles, courtesy of takeovers and share buybacks, which are seeking a home. Finally, investors may decide that even if the US subprime fall-out proves more dangerous, the central bank’s response will be to cut interest rates – making shares look even cheaper.
What does this mean for investors? I’d be surprised if the credit-market wobble didn’t hit shares. But I suspect any setback will prove a buying opportunity. Indeed, I expect shares in Europe’s biggest companies – those least affected by private-equity bid speculation, which are exposed to continuing strong global economic growth, and have most to gain from ongoing consolidation in Europe – are among the safest havens around.
Gordon Brown has usurped Tory territory
It was always clear to anyone who came across Gordon Brown’s gang that he would never fulfil Conservative fantasies by becoming a socialist red in tooth and claw on becoming prime minister. But the extent to which he has wooed business and the City has got the Tories rattled. Last week, shadow chancellor George Osborne sent a forlorn letter to members of the Tax Reform Commission, which he set up and which reported last year, outlining what has become of their work. It makes pretty pathetic reading.
Apart from a pledge to abolish stamp duty on shares and create more reviews to look at the Commission’s conclusions, it only compounds the sense that an impressive piece of work has been kicked into the long grass. Lord Forsyth and his team, who gave up much time to produce the report, must be pretty disgruntled. One of them tells me he keeps a list of their ideas so far adopted by Labour – five to date, including a move to change how foreign dividends are taxed, which Citigroup describes as possibly the most significant tax reform for years. It could pave the way to the UK becoming a major hub for international company headquarters.
All this suggests the Tories will struggle to regain credibility in the City. But do they actually care? Talking to two grandees, including one member of the Shadow Cabinet, I was shocked by their contempt for Big Business and the Square Mile, dismissing it as not representative of Britain, lacking political nous, and obsessed with sucking up to power. All this may be true. But the City is also paid to discount the likelihood of future events. On current evidence, it attaches little weight to the probability of an imminent Tory government.
Simon Nixon is executive editor of Breakingviews.com