These are nervous times for equity investors.
The headline in this week’s Sunday Times Money section screams, ‘Quit shares for cash, investors told’.
More worrying was the comment from Mervyn King in last week’s quarterly Bank of England Inflation Report. The Bank forecast a slowdown, which would certainly be sharp compared to the very small movements we have seen in the last 10 years. Tighter credit conditions will hit the property market and the construction industry.
Moreover, the Governor made it clear that he thought equity markets had not adequately priced risk yet, and warned that a significant risk to the world economy lay in the threat of falling equity prices. Is it time to be truly alarmed – or is this just another blip?
This is not the first time that stock markets have felt jittery during their bull run. In May 2006 the bull market in global equities stumbled. The investment community was deeply divided. Some high profile fund managers like Anthony Bolton at Fidelity believed that the markets had further to fall. We, on the other hand, argued that it was a buying opportunity. The FTSE 100 index was on a historic multiple of 13 times earnings, which was hardly demanding, and lower than the p/e ratio when the market bottomed in March 2003.
But the bears were concerned that the new Fed Chairman, Ben Bernanke, would want to cement his inflation-fighting credibility and slam down the monetary brakes too hard.
But we argued that Mr Bernanke would look at the record of his predecessor for guidance. Alan Greenspan was re-appointed time after time after time because he chose to ignore the vigilantes in the market and instead delivered strong growth – albeit at the price of repeated asset price bubbles.
As it happened, we saw last year’s setback as a buying opportunity. By way of illustration we thought Barclays (BARC) were a buy in June 2006 on a prospective p/e of 10.2 and registered a 28% profit in under nine months. This was a classic contrarian play.
Alas, this year we have egg on our faces. Stocks this autumn in the finance and property sector looked ‘optically’ cheap, compared to standard benchmarks and cheaper than Barclays a year ago, only for them to become cheaper. It was not a mid-summer blip like last year. This correction has considerable momentum.
And it all started so innocuously. Back in February we commented on the complacent atmosphere at the World Economic Forum in Davos. In early 2007 economics seemed to be the last thing on anyone’s mind.
After years of listening to the prophesies of doom about global imbalances, currency chaos, property and stock market bubbles, and unsustainable borrowing, the world’s business leaders were not interested. The dominant tone was exuberant optimism and the challenges of saving the planet.
Given that Davos had such an abysmal forecasting record, we highlighted the fact that there could be turbulence in the financial markets this year because no one was looking and warned that in financial markets liquidity is there until it is not. The trouble is that there was no way of accurately anticipating the timing and trigger of such a shock.
When the sub-prime story broke in early spring this year, we admittedly took a relaxed view. After all, sub-prime mortgages accounted for only 3% of the total value of the US housing stock. The Fed took the view that the impact of the sub-prime crisis was not large and was broadly contained. Indeed it maintained at the time that its predominant policy concern was inflation.
In the event it was the way these unwise loans were passed on that caused the problem. Rather like rumours that sheep spine is being used as an ingredient in meat pies, all of a sudden no one buys them.
In a similar vein, the defaults on sub-prime mortgages have unearthed investors’ worst fears. Those who have invested in financial instruments that lack transparency and have not been valued on a realistic basis face heavy losses.
The saga of the two Bear Stearns hedge funds, which went belly-up in July, was symptomatic. Two months earlier many investors in both funds were nervous about their investments in the hedge funds exposed to sub-prime losses.
They asked to redeem their investments. The funds said no. By mid-July Bear Stearns admitted it could not figure out how much money it had lost. The funds refused to answer investors’ questions. Less than two weeks later they filed for bankruptcy protection.
The lesson of this story is that no one really knew what was going on. When nervous investors can’t get their money out, the sense of panic spreads like wildfire. A sub-prime exposure can remain buried and unexplained for months. Nor is the Bear Stearns debacle an isolated incident.
The case of Merrill Lynch is well known; it announced a write-down provision of $4.5bn just two-and-a-half weeks before it declared a $7.9bn third quarter loss. Analysts now expect further write-downs at the US investment bank in the order of $13bn, shared over this quarter and next year.
In these circumstances when the markets were demanding transparency they were fed denials and obfuscation. There is a general feeling that the people in charge do not have a clue what was going on. No wonder the markets are turning ugly. And when the markets turn ugly, liquidity simply disappears.
A property market downturn threatens
This credit crunch is not blowing away overnight. This week two-month sterling Libor rates have surged to their highest level since the Northern Rock crisis in September. The emerging concern for banks is their exposure to the threat of falling residential property values, and the reality of falling commercial property prices. Last month UK commercial property achieved a total return of minus 1.5%. That was the worst result since May 1990.
Moreover, UK banks have more of their loan book in commercial property, 9%, than they did back then. Banks never thrive when property prices are in decline, and tighter credit conditions undermine property prices further – creating a vicious circle. In these circumstances it is difficult to see an imminent recovery in property and bank shares.
Accordingly for those holding bank and commercial property shares, the options are either to tough it out for the long haul or bite the bullet now and take a loss. Clearly much depends on investment opportunities elsewhere.
In global equity markets the fall-out from the credit crunch has been sector selective. Finance, property and retailing have been hit hard, while sectors oriented to the fast expanding emerging market economies have thrived – like telecommunications, mining and energy companies.
In other words the markets believe that the world economy will survive a period of retrenchment by the US consumer.
How can this be? For years now US households have been the locomotive of the world economy, the spender of last resort. Commentators have been just so accustomed to a stimulus from this source that they just see a global recession if US consumers stay at home after Thursday’s Thanksgiving holiday.
On the face of it the situation looks bleak. Prospects for the US construction industry, mortgage lenders and borrowers are worse than at any time since the early 1990s. The 15% fall in US financial stocks so far this year goes some way to acknowledging this fact. But it is unlikely that we are over the worst.
The direct effect of the US housing slump will approximately take a further 1.5% off of US output and cost around half a million jobs before the slump is over…. No wonder talk of recession is all the rage.
Falling dollar boosts US exports
However, this attitude fails to recognise how adaptive market economies can be. One of the consequences of the US housing slump has been the collapse of the US dollar – the Fed has been cutting interest rates when other central banks are not.
The peak in the US dollar in January 2002 coincided with George W Bush’s notorious ‘Axis of Evil’ State of Union address, since then the greenback has fallen by over 40% against the euro.
This has provided an enormous boost to the US export sector. US exports are growing at their fastest rate for 20 years. The US export sector now accounts for 12% of US output, while gross residential investment takes up only 5%. The upshot is that overall growth in the US economy seems it is only likely to soften, rather than collapse.
The Fed’s latest forecast for economic growth next year is between 1.8% and 2.5%. This is far from a recession, which is defined as a minimum of two consecutive quarters of negative growth.
Indeed, foreign exchange markets move in mysterious ways. Only last week the Chinese commerce ministry warned that the nation’s exports would be ‘devastated’ if the US economy slowed further. The reality is that China’s largest export market is now the European Union, and with the euro so strong, this looks set to continue.
There is also a fear that the fall in US house prices will undermine consumer spending – as households feel less wealthy. But this effect may not be as great as some envisage. The two million households whose homes are at risk from the sub-prime debacle are mostly poor. These households only consume a quarter per head compared to the middle class in the US.
This leaves us with the final fear. How will the US financial system react to the enormous losses sustained by US banks? Here we are back at square one. No one knows where the losses are, and until the situation is clarified, it is an extremely risky proposition to contemplate buying banks or property shares right now. Meanwhile, there are opportunities elsewhere. For example, not all retail stocks face a daunting Christmas.
Finally, in recent weeks, we have been asked what our stance on equities is. It may sound evasive, it is not simply a case of being bullish or bearish. Much depends on where else you would place your money.
Financial assets can be broadly broken down into equities, bonds and cash. We examined the relative prospective returns on these three asset classes on three key dates: 31 December 1999, the all-time high for FTSE 100; March 12 2003, the low point of FTSE 100 this decade and today.
From this it is possible to get a feel of how bullish we are towards equities relative to other asset classes, on a scale of zero to 10, where 0 is extreme bearishness akin to the peak of the dotcom boom – and 10 is extreme bullishness, as in March 2003 when the yield on equities equalled that on gilts. The current rating is nearer 3 than 4.
By Brian Durrant of The Fleet Street Letter.