Stand firm

Financial forecasts don’t look very promising for the next few months, possibly years. So, for schools with investments, is it a time to be cautious? On the contrary, writes Andrew Bell, now is the time to be bold

A year on, the credit crunch seems no closer to ending and has proved far worse than expected, so far defying attempts to call an end to the resulting economic squeeze. Global economies have been poisoned by the toxic interaction between this credit contraction and the recent oil shock. The sustained crisis of confidence in credit
markets has led to pressure on investment banks and other holders of securitised debt instruments to sell them, into
illiquid and unreceptive markets.

Many of those securities were created by bundling US mortgage loans together. Initially, problems began to appear as the more financially stretched borrowers struggled to service their loans, but the deepening correction in the US housing market has created a more fundamental malaise, leading to falls in the value of pooled mortgage securities and fears of further bad debts. This has revealed the extent of leverage in the financial system, which magnified these problems into truly eye-watering capital losses by many financial institutions.

At the end of August, more than $500 billion had been erased from the carrying value of banks’ exposure to such investments, forcing them to raise unprecedented amounts of new capital to plug the resulting holes. Around $350 billion has been raised so far, of which half has gone to UK and European banks, witness to the ability of globalisation to spread losses as well as prosperity worldwide.

More fears
Concerns about write-down hits have given way to fears about slowdown losses, as developed economies slip towards or into recession. Bad debts usually multiply during periods of economic hardship, creating further losses that bank balance sheets are currently ill-equipped to shoulder. As a result, banks have hoarded liquidity and used new capital to bolster their capital ratios, rather than fund new lending. A credit shock to the financial system has transmitted itself into a credit squeeze for the broader economy.

Trustees will be aware that the pain has been particularly sharply felt in the housing and commercial property sectors, which had become overvalued when credit was easy, magnifying their vulnerability when credit became scarcer and more expensive. One problem with this kind of economic contraction is that it can become self-reinforcing. The more asset prices come under pressure, the greater the losses banks suffer, making them over-conservative about lending. Creditworthy companies and families that would normally have access to credit, fall
into difficulties, compounding the problem.

The usual factor that halts this process is when central banks respond by creating abundant liquidity to encourage the controlled risk-taking that underpins economic expansion. However, on this occasion, although the US Federal Reserve has cut interest rates dramatically, lending rates have risen because banks have been correcting from a previously over-liberal position, as well as having to rebuild their capital. This position of scarcer and dearer credit has been mirrored in other regions.

Mounting pressures
The fear that this slowdown would be of a different character to the relatively brief recessions of recent decades has been intensified by the pressure on consumer incomes and corporate margins due to the sharp rises in oil and other commodity prices. At one stage, the oil price had risen almost 50 per cent from its December level, feeding directly into inflation rates worldwide and threatening a return to the mediocre economic performance of the 1970s, when stagflation dogged most economies. Apart from the direct negative impact on growth of the surge in food and energy costs (effectively acting as a wealth transfer from consumers to producers), the resulting rise in inflation has prevented central banks from cutting interest rates to alleviate the pressures on growth. Indeed, the European Central Bank (and many emerging country central banks) has raised rates, adjudging that the longer-term risks of allowing inflation to build outweigh the short-term costs of weaker economic growth.

The twin credit and inflation shocks will weigh heavily on growth in coming months, with further downgrades likely in economic forecasts and corporate profits. There are likely to be further revelations of losses in the banking sector.

Crises create opportunities
These problems, serious as they are, are scarcely unrecognised by equity markets, which have all fallen significantly, especially in the sectors most exposed to the credit squeeze and the risk of recession. It is easy for
trustees to become caught up in the negative mood and become blind to the opportunities from lower prices. Unless there is a substantial and sustained fall in corporate earnings, investing in equity markets at current ratings seems likely to be well rewarded in the long-term, despite the tactical risks. The question occupying trustees is what could catalyse a change in economic fundamentals and investor mood.

The two likeliest recovery factors are the passage of time (allowing the banks to complete their retrenchment and recapitalisation) and the likelihood of interest rates falling during 2009, once the current pulse of commodity-driven
inflation has passed through the system. The surge in oil prices in the spring, followed by a setback during the
summer, holds out the prospect that, although inflation is at higher levels than expected early in the year, the peak is likely to occur this autumn. The fall in energy prices should reduce the headwind to growth (so some economies may not need to reduce interest rates), while reintroducing lower rates in countries such as the UK, where the
mortgage drought and falling house prices are likely to keep consumer spending weak until interest costs begin
to fall.

Structural problems in the UK and US economies are likely to keep growth below par for some years, until savings have been rebuilt and the export sectors have built up their contribution to growth. However, if 2009 proves to be a year of declining inflation and falling interest rates for the UK, with exports responding to this year’s fall in sterling, monetary conditions will become a tailwind for equities instead of a headwind.

Hold firm
There are currently significant uncertainties over the timing of a turnaround in inflation and growth, while the
unfolding credit cycle may yet destroy further wealth in the banking sector. Although it is too late to be running
for cover, it is important to exercise care and patience in investment selection. If growth remains weak and credit
conditions tight, investors will rely on financially resilient companies that are not unduly dependent on an early
economic recovery. With growth scarce, a premium is likely to be placed on sectors and regions where growth is above average. Trustees might consider making wider use of alternative investments, particularly those with a sensible balance between rewards for investors and management fees, and where the underlying assets are less correlated to mainstream bond and equity markets.

If care is taken, these can confer diversification benefits for charities as well as attractive returns over the cycle. At times like this, it is well to recall that in the view of some iconic investors that the best time to invest is when it feels least comfortable. The late Sir John Templeton said that the best opportunities occurred at the time of maximum pessimism, while Warren Buffett believes in being “fearful when others are greedy and greedy when others are fearful”.

Andrew Bell is head of research at Rensburg Sheppards Investment Management.

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