With the Bank of England’s rate cut ringing in our ears, I wanted to provide you with the market comment by one of our fund managers John Husselbee. We hope you find these thoughts helpful. – Andrew Williams, Chief Executive, City Financial
“‘Would you tell me, please, which way I ought to go from here?' Alice speaks to Cheshire Cat”
Alice in Wonderland continues….. ‘That depends a good deal on where you want to get to,' said the Cat. ‘I don't much care where--' said Alice. ‘Then it doesn't matter which way you go,' said the Cat. ‘--so long as I get somewhere,' Alice added as an explanation. ‘Oh, you're sure to do that,' said the Cat, `if you only walk long enough.' -- An Extract from ‘Alice in Wonderland’ by Lewis Carroll
You may recognise this passage from Alice in Wonderland; it was once quoted to me during a training day entitled “Strategy and Planning.” What followed was an in depth examination of the Chaos Theory, I will spare you the details!
The point of digging out the conversation between the Cheshire Cat and Alice is that she was going on a journey but she didn’t know where she was going. It seems that of late, financial markets are walking a similar path and getting to a place where they just didn’t want to be. Many market participants have arrived at what can only be described as the Madhatter’s tea party with a host of journalists on hand to report every detail. At times there is just too much noise to hear yourself think!
So let’s turn down the volume for a moment and consider where we are. There is no doubt that the economy is slowing rapidly and we are now heading for a recession in the UK, US and Europe. Share prices in the long term are driven by company profits. When the economy is shrinking, so are those profits. Analysts are busily employed in the City forecasting future company profits and how far they may fall. But first they will need to determine the depth and the length of the economic slowdown. The problem is they are all agreed that company profits will fall but cannot agree on how far. This is naturally making investors cautious and is the cause of much of the current volatility.
At the hedge fund side of the table there has been even more noise. Hedge fund returns have disappointed investors who are now voting with their feet. Redemptions from investors together with tightening lines of credit mean that some hedge fund managers are being forced to close positions to realise cash. Whilst the estimates on the size of redemptions range wildly, prices are being pushed down and volatility pulled up. The VIX, the volatility measure of fear & greed, bears this out hitting record levels of late.
On Thursday the Bank of England slashed interest rates by 1.5% to 3%, a level not seen for over fifty years. The shock tactics used by our Central Bank have now left us thinking “what do they know that we don’t?” The cut has been announced on the basis that our economy is known to be rapidly deteriorating as house prices continue to fall and unemployment rises.
In the context of history, the magnitude of the move is unprecedented. We usually see central banks raise interest rates like an escalator to cool the economy, then cut them more like an elevator to foster growth. It is fair to say that I along with everyone else thought that interest rates were to be cut by 0.5% but being out by a full percentage was totally unexpected. It seems we are now in the express zone searching for the new base level.
Why has the MPC been so bold? As we know the mandate of the Bank of England is to target inflation. This Labour government gave them the independent license to maintain inflation at a level of 2%. Whenever this is exceeded they must write an explanation to the Chancellor. Earlier this year, with food and energy prices rising sharply, they were in regular correspondence. However the oil price has halved since July and food prices have tumbled too. So with prices at the pumps falling and the cost of the weekly shop down, the Bank of England will soon have the recorded data in their hands to justify their move. Obviously this is good news for those who borrow but not so good for those who save.
So that’s where we are, lets think about where we are going. There is a belief that financial armageddon has been avoided by the ‘better late than never’ policy response. Governments and central banks have woken up to the realisation that this is a global crisis and one that requires a global solution. We have already seen and will continue to see concerted efforts to alleviate the financial turmoil in the form of bailouts and rescue packages that are best rounded to the nearest trillion of dollars. The US TARP was finally approved at the beginning of October and interest rates around the world have been cut. We are not suggesting that there will be a quick fix here but there is now a willingness to do what it takes as the authorities race to get ahead of the curve and take control of this financial crisis.
Until now sentiment has been extraordinary negative in the financial markets. Nobody expected Lehman Brothers to fail and the domino collapse of household financial institutions that followed in its wake. The regulatory environment clearly allowed some unfavourable practices and these will take time to resolve. Short term it is important for the credit markets to function properly again, for it is credit that lubricates the engine of the financials markets, without it everything seizes up. Banks need to be recapitalised and this is now taking place to reduce their leverage. This will lead to the credit markets normalising and restoring confidence amongst investors.
Whilst negative sentiment is hitting the high end of the scale, the measure of value in both the credit and stock markets is noteworthy. One of our favoured bond fund managers points to double digit yields of some world class companies. Their coupons are contractual obligations and will be paid out annually provided that they can avoid insolvency. For equities, despite the lack of visibility and the forced sellers, already mentioned, valuations are cheap by historic measures and yields, which can be cut, compare very favourably to government debt. So what we have seen, in the last week, is bargain hunters, predominately the value managers, scooping up stocks.
There is no doubt that the past six weeks have given investors a white knuckle ride that would test anybody’s faith in financial markets. There may be some who want to get off now, some who are concerned but will stick it out and even those fully prepared to take more. The key is to avoid being the investor who gets off near the bottom, takes a large loss and gives up any potential for recovery and future growth.
So we need to remember Alice. She was on a journey where she did not know where she was going. I was always taught that successful investing required that you identify your destination. That way you can plan the route and that route will depend on the risk you are willing to take and the time you have to get there. What is certain is that the journey will not be at a constant pace, there will be both clear roads and traffic jams. Of course, it is not wise to invest monies in long term risk assets if you are nearing your destination. However, if you have a further five to twenty years to go on your journey then now could be a good opportunity to gradually build your exposure to risk assets at bargain prices.
As always, I welcome your comments and thoughts.
All the best,
John Husselbee, Fund Manager – MultiManager range
City Financial Investment Company Limited