Commentary – Quarterly bulletin, May 2008

A break in the cloud

2 May 2008

Recently there have been some tentative signs that maybe the worst of the credit crisis has passed, at least for the financial markets.

Banks have been raising new capital and private equity funds have bought some bank assets. Various initiatives have been announced, including the Bank of England offer to swap illiquid assets for gilts, which should help to get the money market moving again. It appears that the failure of Bear Stearns in the US marked a watershed and that market participants believe that the crisis has now been contained.

It is too early, though, to sound the all clear.

Banks are continuing to take writedowns on their securitised assets and ominously are now starting to increase provisions against bad loans on their more conventional lending portfolio as the global economy weakens. This is delaying the rebuilding of confidence in the wholesale money market which is needed for the banks to resume more normal lending policies. The extent of the banks’ funding problems can be seen in the first chart which effectively plots the premium that UK banks are paying for funding above what the UK Treasury pays. Normally this premium is quite low but has shot up since the crisis erupted and partially explains why borrowing rates for bank customers have not tracked the cuts in base rate.

The economic outlook has been worsened by the banks’ problems. The global economy was already showing signs of slowing after a period of above average growth but now the constrained credit conditions threaten to intensify the slowdown. It looks like the US is already in recession and forecasters are leapfrogging each other in reducing estimates of global growth for this year and next.

It is likely that financial markets will remain volatile for a while yet until we are more certain of the extent of economic weakness. Nevertheless, the extremes of downside risk seem to have been averted and investors should be viewing periods of weakness to increase equity market exposure.

Equity markets have been showing some signs of bottoming after the sharp falls between September and March.

Although the economic outlook has deteriorated and with it the prospects for corporate profits, investors have become more sanguine. The weakness in markets has generated more attractive valuations and investors are prepared to look beyond what they see as a relatively short term economic slowdown.

There are two key factors on the positive side. Valuations compare favourably against other asset classes, with for example, UK equities at the most attractive level relative both to cash and gilts for at least 20 years. Measures of investor sentiment, used in a contrarian way, are also signalling that equity markets are more likely to trend higher rather than lower over the next year or so.

On the other side of the equation, monetary conditions are still exerting a negative influence although this may change if short term interest rates continue to fall and these are finally transmitted to borrowers. Perhaps more significantly, profit expectations do not yet seem to fully reflect the impact of the economic slowdown. In recent years, profit margins have risen to near record levels in many countries and in a period of weaker economic activity there is scope for a considerable fall in profits. The difference between input and output price inflation provides a rough insight into near-term changes in profit. The second chart plots this inflation differential for the UK manufacturing sector and also plots an index of overall UK corporate profits. It appears that neither investors nor companies have fully built in as much profit weakness as this analysis suggests. This leaves scope for disappointment with company results announcements as we move through the rest of the year and this could destabilise the markets should it occur. It is well to remember, though, that equity markets tend to bottom well before the trough in profits.


The belief in the containment of the credit crisis is also showing up in the bond markets.

Yields on developed-world government bond yields (regarded as risk-free) have risen in the past few weeks as investors have been prepared to switch into riskier assets. At the recent low, risk-free bond yields reached almost as low as they were at the extreme some years ago. Risk-free bond yields are set by the market at a level to compensate investors for expected inflation and provide an additional ‘real’ return. At the recent lows, investors were prepared to accept a real return significantly lower than the historical average reflecting their high degree of risk aversion.

Sterling has become the fall guy in the currency markets in recent months.

A combination of factors including concern about the housing market, the significance of the financial sector to the UK economy and the prospect of interest rate cuts have weighed on sentiment towards the pound. At least it has brought some benefit to investors in the form of higher returns from foreign investments. Since the mid-1990s sterling has shaken off its earlier systemic weakness and the current weakness is likely to be temporary.

The commodity bull market remains intact (for now).

After a sharp rise in the first quarter, most commodity prices have taken a breather of late. Oil and gas however have continued to rise due to various supply disruptions. Various studies have tried to assess how much of the bull market has been caused by the huge rise in financial market participation in the commodity markets in recent years and the answer (unsurprisingly) is ‘significant’. While there is undoubtedly an ongoing strong structural shift in the supply/demand balance, we should nevertheless be prepared for a meaningful cyclical correction at some time.

In summary, there are signs that the gloom in the financial markets is beginning to lift.

It will not be all clear skies from now on and investors should be prepared for further squalls of market volatility. Nevertheless, they should be more prepared to see market weakness as buying opportunities.

— Ken Forman

Ken is an investment business consultant who spent 30 years as an analyst and portfolio manager at Standard Life Investments.