Credit defaults will continue to punish markets

published 28 April 2008

In the previous issue two weeks ago, number 568, we published charts for the UK, US and European stock markets. In each, the up trend from 2003 was violated decisively and prices were consolidating below the 30-week moving average and the 50% retracement level.

In spite of all manner of news, prices still remain below those very significant technical levels and whilst they do, we think, it is more likely that the downside will be resumed and the bear market sustained.

The executive director of the government of Singapore's Investment Corporation, the third largest sovereign wealth fund, said we could be facing a recession which is longer, deeper and wider than any recession we have ever encountered in the past thirty years.

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Richard Lambert, head of the CBI, warns companies to batten down hatches ahead of the economic downturn.

Credit defaults will remain a big story this year and why would that not be the case? Credit contraction is real and will continue to grind asset markets down, just as we have said in the opening paragraph of this section and would have repeated in each issue since 4th December last year.

Tommaso Padoa-Schioppa, Italy's Finance Minister recently said "If we think that solving or emerging from the crisis means going back to the continuation of growth before the crisis, we would be making a mistake, because we were on an unsustainable path."

The actions of the Federal Reserve, the Bank of England and the European Central Bank are all assisting to mitigate, to some extent, the effects of this credit contraction. However, and this is perhaps the most important simple truth to be retained, banks will not return to the lending practices that were prevalent until last year.

Going forwards, they will insist on only lending sensibly, relative to the security offered, and prudently, relative to the credit risk of the borrower. Any deal that doesn't fit comfortably within those two parameters will be refused. Any loan set up in the conditions prevailing previously that needs to be refinanced will face trouble and even if it can be arranged, will be at higher rates of interest and the loan offered may be insufficient to repay the outstanding one.

On Wednesday 23rd April, Jim Pickard, George Parker and Sharlene Goff wrote an article in the Financial Times headlined "Lenders give little solace on mortgages". To quote from the article "Lenders yesterday told Alistair Darling that they could not throw an immediate lifeline to beleaguered mortgage holders by passing on cuts in base rates - and warned that repossessions could rise in the coming months." They also told him that the new Bank of England £50 billion facility for lenders to swap mortgage- backed securities for gilts would not reverse the newfound aversion to risk by banks, which has led to a tightening in lending criteria at the expense of low income borrowers and buy-to-let investors.

The housing market in the UK is sending frightening signals and the realisation has at last sunk into people's heads that for some time now, it has been cheaper to rent than to buy a major value-destructive sentiment reversal. Owners of buy-to-let properties are in for a rough time, yields will rise, triggered by greater demand for rented properties - the good news. But the decline in property values will sweep aside that benefit.

It's all quite simple really on the back of an envelope roughly calculate how much it costs to own a property. Take into account rates of interest for the whole value of the property, buildings insurance, repairs and, if let, void periods. Assuming the interest rate is 6%, a reasonable estimate of what it costs to own a property is about 10% per annum. This week the news was that yields have increased slightly from 4.8% to 5% - yields so low that they are only bearable in a raging property bull market.

To rent rather than buy today is a very good choice and will probably remain a good choice until the yields rise above 10% per annum. Somewhere around that point, it will become cheaper to buy than to rent a level when value returns to the market. It will be interesting to see later how interested people are in buying then. Sadly, only when property is too dear, does everybody want to buy it. So when yields are over 10% and property is good value again, only a few buyers will boldly step up decide now to be one of them!

Commercial property in the UK has suffered badly as those unfortunate investors in commercial property funds have discovered. According to the

Financial Times, capital values in the UK fell 1.3% in March, having fallen 2% in January and 1.5% in February. This was coupled with the bleak news that the City expects rental growth this year to be at minus 16% per annum.

Unsurprisingly, investor discontent is stirring and threats of legal action are being mooted by investors who claim they were never properly advised on how dangerous property funds could be because of their innate illiquidity. We can at least claim that this newsletter, in good time, rammed home that point many times.

As always, sentiment moves around and of late there has been an expectation that the commercial property market may be bottoming out. Below, you will see the chart of the Real Estate sector of the UK stock market from 2003. To date it has given up more than 50% of the considerable gains. This year it has been consolidating in the trading range below one of our favoured indicators, the 30-week moving average.

This period of consolidation and the proximity of the 30- week moving average should lead to an important signal. The top of the range is 3883, strength above that would be an aggressive signal to buy UK commercial real estate. The bottom of the range is 3329, a clear break below that level would suggest an eventual test of the 2003 low. When charts develop price action such as this, the signals that ensue will invariably have enormous consequence and they are generally very reliable.

We constantly hunt for new opportunities. The Chinese stock market is one of them, as are India, Russia, Taiwan, Japan and some other Asian stock markets, including Vietnam. Price Waterhouse Coopers say that China will become the biggest economy in the world by 2025. Since October last year, the Chinese stock market has lost almost half of its value.

The authorities yesterday reversed the tax decision made in May last year by reducing the tax on stock purchases from 0.3% to 0.1%. So far, and immediately after the announcement, the Chinese stock market reacted very, very positively, it could, we think, very soon deliver an early opportunity to buy. We will be actively looking out for that.