With uncertainty, comes opportunity

Markets have been buffeted by an astonishing chain reaction of events in recent months, complicating the usual uncertainties over the outlook for economic growth with deeper questions about the functioning of financial markets, writes Chris Hills

The nationalisation of a UK bank, an emergency rescue from near failure of a US investment bank and widespread evidence of failed risk management models across the global financial system have rattled already jangled nerves in financial markets, leading to contagion from the areas seen as higher risk, such as sub-prime US mortgages, to assets previously viewed as near to government bonds in credit quality terms.

To the ordinary investor, instruments such as debt issued by semi-official US state agencies involved in the mortgage guarantee business appear arcane and of minimal relevance to them. However, the evaporation of confidence and, for a time, the complete absence of normality in their market prices led to a much more substantial threat posed to the whole financial system, on which depended the pricing and liquidity of more traditional portfolio investments. As the celebrated economist John Maynard Keynes noted, markets can stay irrational longer than investors can stay solvent. It has therefore been crucial that central banks tackle the cause of this irrationality, namely the lack of trust in capital markets, before its symptoms, the lack of normal liquidity, create lasting damage.

Home issues
In the UK, efforts are being made to restore trust but the growth rate of the economy has weakened from the brisk rates enjoyed during 2007 and recent years. The increased cost of mortgages, allied to reduced competition to offer loans, seems likely to restore awareness of the law of gravity in a housing market where prices had moved ahead of the ability of new buyers to afford them. There are also concerns that investor landlords might sell if the returns generated by house price inflation dry up. New construction is slowing and services dependent upon housing transactions are likely to suffer.

At the same time, rising import costs (a function of weaker sterling) and higher food and fuel prices (the commodity cycle at work) are squeezing consumer spending power and corporate margins. The main consumer engine of growth in recent years is spluttering.

The weaker pound will help industries and services sensitive to foreign competition, offsetting the headwinds from the impact of less benign credit conditions on an over-indebted consumer sector. As a result, a grey period of mediocre growth seems likelier than a sharp slowdown. Since this is what the Bank of England (and others) probably judge is necessary to ease imbalances in the UK economy, gradual rather than precipitate falls in interest rates seem likely. Although some of these falls may not be reflected in mortgage rates as lenders seek to rebuild their margins, they should, given the preponderance of variable rate loans, provide some support for economic growth in 2009.

Across the pond
The US Federal Reserve has been extremely active in its attempts to manage the crisis of confidence and regain control over the pace at which the credit bubble of the early years of the century deflated. In doing so, it has sharpened concerns about the vulnerability of the US dollar, as a currency whose economy faces adjustment problems and a substantial trade deficit. A side-effect of this has been the emergence of something approaching an investment mania in commodity markets, with investors chasing prices higher as a hedge against higher inflation or the weak dollar. Although there are respectable arguments why commodities may enjoy stronger prices in coming years – rooted in burgeoning demand from emerging economies – the pace of commodity price inflation appeared to reflect flows of speculative hot money more than any new revelations about Asian industrialisation.

Whatever the cause, the rise in energy costs and the price of many raw materials in the food industry has complicated the central banks’ task in setting policy to counter waning economic momentum. The result was “perfect storm” conditions in which market volatility, tighter credit and a squeeze in profit margins and living standards driven by commodity cost increases have caused consumers and companies to become very nervous about the immediate future, ploughing the fields for the seeds of recession to take root.

The acute malfunction in normally liquid markets has led central banks to switch focus from their usual concentration on setting the appropriate cost of borrowing for prevailing conditions to addressing the self-feeding collapse in confidence which became especially acute in March 2008. Unlike consumer goods, which tend to attract more buyers the cheaper they become, the value of financial assets depends upon confidence in the issuer’s ability to repay and on the ability to exchange them for cash in open markets. Steep falls in price can become self-reinforcing, especially if some investors have funded their portfolios with borrowed money and become forced sellers into falling markets.

Looking back
This brings back memories of 2002-3, when insurance companies were forced sellers of equities near the market bottom. In such circumstances, a downward spiral can develop, involving forced sales of relatively secure assets to meet repayments of loans used to purchase riskier assets. When inexplicable falls in secure assets occur, others sell just in case and a market panic ensues. Prices can become divorced from the ultimate repayment value, in which circumstances the financial authorities’ role is to restore confidence, putting a fire break between the genuinely problematic assets and those cross-infected by fear. Re-establishing the “pulse” in markets may not eradicate damage from the initial disease but the absence of functioning markets is as fatal for economic stability as circulatory failure for living organisms.

The risk of bailing out financial institutions from the consequences of their errors can be justified by the fact that the sufferers of financial contagion are often remote from the creators of the problem – hard to justify in a democratically accountable system. The high profile rescues to date have also preserved the banks’ infrastructure (eg deposit and lending businesses) without protecting shareholders from the costs of failure.

Sentiment is currently fragile, not only in equity markets but in the real world. If central banks succeed in their efforts to calm nerves, then existing problems will appear manageable, having been well aired in recent months. Otherwise, the economic outlook will worsen until the authorities are forced to take even more radical measures to improve the liquidity and solvency of the financial system. They have made clear that they are committed to do so but presumably hope they will not have to.

How far?
The recent market setbacks have been unprecedented in their nature, although not exceptional in scale. The breakdown of the normal market mechanisms for distributing risk makes it hard to assess how far known problem areas of the economy will cross-infect apparently unrelated areas. For the financial sector, this worry is compounded by the open-ended process of loss disclosure and the degree of financial deleveraging under way.

Authorities, especially in the US, have put in place a wide array of measures to tackle problems of market malfunctioning as well as the cyclical deterioration in the economy. These have had so little time to act that investors have yet to assess which apparent credit and equity opportunities are real and which are traps. We would expect a period of consolidation to come before any durable bounce-back, but lean towards those who believe the exceptional measures taken will prevent a lasting US recession, or one at all elsewhere, and should allow 2009 to be a year of better growth, to be discounted at some stage during 2008.

If the measures to tackle market confidence are now in place, a fall in energy prices is worth watching for as a possible pleasant economic surprise, which would take the pressure off inflation and personal incomes. Unfortunately, it is not within policy-makers’ gift.

The prognosis is good
We expect emerging markets to continue to grow more rapidly than their more mature counterparts and see recent setbacks as an opportunity to add to holdings, especially for those who had not previously bought into the theme. Commodity and consumer goods stocks can be an indirect way of playing this but, as noted earlier, direct commodity investment appears a crowded trade at present. More generally in equities, pressure on margins appears likely and the global recovery may be slow, so earnings visibility and structural resilience are more reliable themes than a market re-rating.

In the credit markets, the forced selling by some over-borrowed investors has created unduly cheap valuations and the best buying opportunity for many years for investment grade credit. High yield credit remains subject to too many cyclical uncertainties but investors are now paid to shift from the security of government bond markets to high grade corporate and mortgage backed bonds.

This seems an environment of strategic investment opportunity, littered with tactical pitfalls. Accordingly, we expect it to be some time before investors step up their risk levels appreciably. Equally, with so much bad news widely known, running for cover would be like driving using the rear view mirror.

There are early signs the authorities are managing to restore some order to markets, after a losing battle for several months, although it remains unclear whether this is misery fatigue or the battle for confidence turning. We remain watchful but are not negative on the outlook.

Chris Hills is chief investment officer for Rensburg Sheppards Investment Management.