Not for decades has the UK seen a ‘run on the bank,’ but that changed this month with the fiasco at Northern Rock. If ever there was a financial crisis brought about by the financial community itself, this was it. Real businesses around the globe had been enjoying very favourable economic conditions. It was the money men that brought a problem on themselves. Whereas previous sightings of the credit crunch monster had taken the form of investors finding themselves holding bad investments, Northern Rock heralded a new twist in the story.
The problem was simply in the way that it had financed its business, relying on short-term credit markets to finance its book of long-term loans. That was a strategy that worked — and enabled Northern Rock to grow its business rapidly — right up to the day that the short-term credit markets were simply closed for business.
There is a startling lesson here not just for shareholders in the banks, but for owners of any ‘geared’ asset. This includes any homeowner with a mortgage loan and any shareholder in a company which has debt. It is not enough just to say that the level of debt relative to the value equity is low and therefore prudent. It is necessary to know when that debt is due for refinancing. If it happens to fall due at a time when markets are not providing that sort of finance anymore, pain can ensue and equity can vanish.
The position of equity holders in financial businesses is extremely precarious right now. That is an over-generalisation, but it will be the financial sector that reports losses first. Northern Rock was not brought down by its depositors (the Government stepped in to ensure that). Nor was it brought down by its borrowers (unlike in the US where some mortgage banks’ loan books have turned bad). It was just the money men within Northern Rock and the City. They financed the business in an innovative but precarious way and it did not work out. It has happened before and it will happen again. Shareholders take the hit and everyone moves on. We emphasise this because, at this stage, it does seem that Northern Rock’s problems are not indicative of a broader economic problem that would drive us to switch out of UK equities.
However, no sector operates in a vacuum, particularly not the financial sector and particularly not in the UK where the City accounts for a chunk of GDP. There has to be a spill over into the wider economy, but it can be modest outside of the US.
A pent up wall of Chinese money waits
Indeed, there is whole new driver of economic growth in the world — China. More specifically, the industrialisation of China and the build-out of its massive infrastructure requirement. This is not a phenomenon that depends on the fleeting strength of the Chinese consumer. It is going ahead and the money to pay for it — witness China’s staggering foreign exchange reserves — is sitting in the bank.
Indeed, Chinese capital is making itself felt not just in the real economies of its trading partners, but in the financial markets too. Here its distorting effects are creating pockets of boom conditions, but equally setting the scene for a tumble that fragile markets in the West could better do without right now.
Hong Kong’s Hang Seng index rocketed by more than 25% between mid-August and mid-September, while other markets were on the skids. Behind the surge has been confirmation that the Chinese authorities will relax the previous restrictions on domestic banks, insurance companies, asset managers and securities firms to invest outside of China. This Qualified Domestic Institutional Investor (QDII) scheme was first announced in April 2006, but as of May 2007 was still restricted to a total quota of US$18.8bn. Reflecting these restrictions, the pricing of Chinese companies listed in Hong Kong (H shares) had been running at levels significantly below the pricing of Chinese companies listed in China (A shares). It is the China shares listed in Hong Kong that are already most familiar to Chinese institutional investors and are most likely to be the first recipients of QDII cash. Figures in the region of US$2,200bn have been put on the total value of domestic renminbi deposits in China. Clearly China’s potential to export capital is now immense, and marks a new chapter in the China growth story.
Putting sentiment aside, the outlook for earnings is opaque right now. This is particularly so for banks with US and UK business, and interest rate sensitive plays such as property and construction. It may yet turn out that ample pessimism is already priced in, with banks and housebuilders already marked down onto single digit PERs. However, with financial sectors dominating the major stock markets, several key equity indices have a tough time ahead. As ever, we continue to profit from picking individual companies and funds. Our global funds such as Bankers Trust and Jupiter Merlin may not be able to perform in these conditions, but our specialist situations such as HSBC Greater China certainly can. Indeed, the Zurich Club’s long-standing support of emerging markets, oil, gold and other metals is reaping real rewards.
ANDREW VAUGHAN, INVESTMENT DIRECTOR
