There are times when it is not right to be invested in equities, and this is one of them. This is a flagrant generalisation of course — and there will always be some individual equity situations that can prosper — but we are saying it nonetheless. It is not that we think valuations are excessive. Indeed, earnings yields are comfortable relative to the price of money, or interest rates. Nor do we think that sentiment is overly bullish. Rather, investor sentiment has taken a big knock in recent months. It is simply that very significant sums of capital have been destroyed in the one sector that inescapably impacts on all other sectors — the banks.
Consequently, debt finance has not only increased sharply in price, but is also much reduced in availability. That leaves many a business and consumer no longer able to access sources of finance which were perhaps taken for granted. We are still months away from being able to put a figure on the losses suffered by the banks; we need to reach financial year-ends and have independent auditors — not in-house shufflers — put a figure on the losses. In such situations, equity value — whether it be personal or corporate balance sheets — can melt away rapidly.
Rates cut, but the problem remains
Of course, it is not just the banks that are suffering. The workings of the whole economy rely on the health and smooth running of the banking system. The knock-on effects of problems in the banks can emerge in the most unexpected places. An individual company may be debt free and operating in a buoyant industry. But that is not enough; if its customers or even its suppliers cannot get the credit they need, then it is going to suffer too.
The US Federal Reserve and the Bank of England cut interest rates this month in a move to make credit more affordable. While this did nothing to boost their inflation fighting credentials, it helped the equity markets, and some very strong rallies ensued. The pulse rate of the banking sector, however, showed little improvement, with LIBOR — the rate at which banks lend to one another — not mirroring the base rate reduction as it normally would. This stickiness of LIBOR shows that credit is priced at a premium to base rates, implying that it is in less than abundant supply. It also demonstrates that central banks are perhaps not able to dictate the level of interest rates in quite the way they always did. They can certainly help to boost demand with attractive pricing of credit, but the market will still not function if there is inadequate supply. And that is where credit markets are right now.
The global picture
Currency dislocation is another headache facing investors, with the Fed’s rate cutting doing nothing to bolster a weak dollar. Although the recent cut in sterling interest rates limits a widening of the interest rate differential between sterling and the dollar, euro interest rates have been kept on hold. While it may be fair to say that over-indebted and weak housing sectors are primarily a US and UK problem, the weak dollar is creating additional problems of its own. For the US it spells imported price inflation. For exporters in
Europe, and notably export manufacturers in Germany and France, the resulting strong euro means reduced export price competitiveness and loss of jobs. This is particularly the case where competing manufacturers are based in the many Asian countries whose
currencies are pegged to the US dollar. The spectre of regressive trade protectionism becomes a real prospect in 2008, particularly with US elections looming.
As with last month, China continues to provide a bright spot, not just in the demand that its economy creates for products from the rest of the world, but in the new found mobilisation and export of its own significant capital base. The listing of substantial Chinese businesses — such as China Railways this month — and the frenzied investor enthusiasm for them has helped to keep potentially wider gloom at bay. Indeed, it was only in late February of this year that wobbling Chinese stock markets were having the opposite effect and sending other markets into a spin.
The mobilisation of Chinese investment capital into overseas markets continues to be felt, with the natural resources sector at the forefront. This month has seen a US$1bn takeover bid by China’s largest steelmaker, Sinosteel, for Australian iron ore explorer Midwest Corporation and a US$450m bid by China Minmetals for Northern Peru Copper, listed in Canada. BHP Billiton’s proposed takeover of Rio Tinto may yet force China’s hand in its continuing quest to secure the raw materials for its ongoing industrialisation. This is an enduring Zurich Club investment theme.
