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Thursday, August 21, 2008

Rowan Stockmarket and Economic Outlook

Spring 2008

The first part of this year has been one of great uncertainty in which equity markets fell sharply and fixed interest markets offered little protection, except in the form of Government bonds. Risk aversion was the name of the game as investors across the world focused on the implications of the credit crunch and the severe shortage of funds available to banks. Central banks pulled out all the stops to put confidence back into the financial system and their efforts seem to have been rewarded with more stable markets; indeed the equity markets have recovered strongly from their low point in March.

United States

In the last edition we asked “Is the US economy about to sink into a recession?” Today the overwhelming view is that the US is now in recession. The obvious question to now ask is ‘how deep will it be?’ The housing market in the US continues to deteriorate and the impact on the wider economy is being felt. In recent years by far the largest number of jobs created has been in the house building sector and of course there is a strong knock on effect from the lack of house sales. Retailers in particular suffer as demand for white goods and other household products falls away sharply. The dollar remains weak but there is growing expectation of it strengthening this year. In the meantime exporters have been performing strongly.

Despite the gloomy outlook for the housing sector there has been a fundamental ‘fiscal’ change. As the financial crisis deepened the Federal Reserve took decisive action and cut interest rates to just 2%, down from 5.25% last summer. This ranks as one of the fastest set of rate cuts in the Federal Reserve’s history. Not only this but they have taken other supportive action; banks can now deposit with the Federal Reserve a much wider range of ‘assets’ as collateral against loans. But the most high profile event was the rescue of Bear Stearns in conjunction with JP Morgan. This signalled that the Federal Reserve was going to support the banking system and not let banks go bankrupt. Of additional importance was the fact that Bear Stearns was not a ‘first division’ bank. The intention seems to be to support the ‘system’ but not worry about the holders of bank shares. In doing this a clear message is sent to the banks, that they will not be bailed out of their risky business activities when they go wrong, but measures will be taken to preserve the stability of the financial system.

As the credit crisis recedes the focus is now on the real economy, with every set of statistics analysed for evidence of further slowing or recovery. At periods such as this the statistics will paint a mixed and contradictory picture and we have to wait until a trend becomes firmly established to understand how deep or otherwise the recession will be.

UK

The UK financial system has been suffering the same strains as the US financial system but the Bank of England has been less supportive. This is partly because the Bank of England’s remit is to maintain/target inflation at 2%. The problem is that inflation is being driven by cost push factors and is not a result of demand. With the oil price at $125 a barrel and food prices rising there is nothing the Bank of England can do to counter these effects. Traditionally they would raise interest rates to ‘choke’ off demand, but a slowing economy requires interest rate cuts and the Bank of England is fearful this will drive inflation higher. However, like the Federal Reserve, they have agreed to take as collateral a wider range of assets from banks and this has helped ease the liquidity situation. With interest rates at 5% and inflation at 3% the Bank of England has signalled there will be no further interest rate cuts for some while.

Evidence of a slowing housing market continues to build with house price falls reported from across the country. The facts seem to be simple; lending by banks helped to drive house prices higher but the credit crunch has resulted in the banks becoming much more cautious. They have withdrawn a significant number of mortgages, self certification is highly restricted, deposit margins have increased and few if any 100% mortgages are available. In addition, as fixed rate mortgages have come to an end, new and much higher rates have been applied. All of these factors apply downward pressure on the housing market and none of this bodes well for consumer spending and economic growth.

The stock market however has powered ahead since its low point in March, although it should be noted the banks have not taken part in this rally. Instead it has been led higher by mining and resource stocks, just as it was prior to the credit crunch. Takeover activity is still centre stage with Rio Tinto and Biliton. Whilst the stock market recovery is welcome the performance of the resources and mining stocks has a look to it that is reminiscent of the technology bubble.

Europe

The credit crunch surprisingly revealed the Swiss bank UBS to be one of the big participators and losers in this crisis. They have revealed losses of almost $38bn which has severely dented their reputation as a conservative bank. Although European consumers are not indebted to anything like the same extent as UK and US consumers and are less interest rate sensitive, the economies of Europe are still exposed to the forthcoming downturn. However recent economic data has painted a much brighter picture for the first quarter in 2008 than was expected, whether this was a blip only time will tell but ultimately we feel Europe should suffer less than the US and UK.

Japan

First quarter GDP data for Japan was stronger than expected which proved the consensus expectation wrong. Many companies are on very cheap valuations especially those in the mid and small cap sectors, however the absence of domestic buyers remains a barrier to the market performing. Japan looks attractive on certain measures but due to the deteriorating global economic situation seems unlikely to decouple from other global markets.

Far East and Emerging Markets

The de-coupling arguments proved of little merit as stock markets in the region fell very heavily as the credit crunch unfolded. Economically they do look stronger than western economies but the dependence on resources in many of the countries still makes them vulnerable to the commodity bubble deflating. Inflation is causing great concern as it is being driven by rising food prices. In China the Government is attempting to control it through price fixing and by raising interest rates. Interest rate increases are also a feature of other economies India, South Africa and Brazil have all raised interest rates. Whilst the growth story for the region remains in place long term, areas of economic vulnerability can be seen.

Summary

The second half of 2008 is likely to prove challenging for fund managers and we are sceptical of the present stock market rally. We believe fixed interest has passed its low point for the year and see investment grade bonds offering particularly good value. Long term the Emerging Market and Far Eastern economies are attractive but recent falls have reminded investors they still carry higher risks than developed markets.

Rowan Investment Team
May 2008