Every six months the Bank of England publishes a Financial Stability Report. This event normally passes relatively unnoticed, but after the traumas of the US sub-prime mortgages and the collapse of Northern Rock, the edition published on October 25 was an exception. It constituted the most bearish commentary on global markets to come out of any major central bank.
It provided an initial assessment of the causes of the recent financial turmoil and the prospects ahead. The causes can be summarised as follows. Many low income Americans had been induced to take out mortgages with attractive starting rates. At the same time, investors bought bundles of debt (asset-backed securities), including these sub-prime mortgages, which offered an attractive yield. However, when US market interest rates rose, low income borrowers faced sharp increases in repayments and many defaulted. Consequently, the asset-backed securities plummeted in value.
Moreover, lack of transparency in offloading these debt obligations meant that no one knew who was sitting on these losses. In response, the banks simply stopped lending and started to hoard cash. Some organisations dependent on the wholesale money markets, like Northern Rock, went bust.
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A painful - but necessary - process
This is not all bad news. In the process, the financial system started the transition from an environment in which liquidity and credit-risk were absurdly under-priced to one in which they are assessed and managed more discerningly.
This transition will take time to complete and the path may not be smooth. Structured financial instruments need to be priced realistically and losses disclosed. Some investment vehicles may need to be wound up, and some financial instruments may need to be restructured before market liquidity can be fully restored.
The Bank of England believes that we are not out of the woods yet. An indication of the trouble to follow is evidenced by the announcement last week of a $7.9bn write down on mortgage related securities by Merrill Lynch, just three weeks after the investment bank gave an indication of losses in this sector of $4.4bn.
The worry is how could Merrill Lynch get the scale of the exposure so badly wrong? Was it not conservative enough the first time round? Or was it simply unaware of the scale of the problem? Neither explanation will serve to calm the market's nerves and both will renew the fear that there might be more monsters lurking on investment banks' balance sheets.
In particular, Merrill Lynch is the first investment bank with an end-September account date to report. At the moment, the markets still do not know where the other bodies are buried' and so the financial markets are still sensitive to further shocks. [Prior to this week-end's announcement] broker CIBC claimed that Citigroup would need to raise more than $30bn in capital to cover credit obligations, most likely at the expense of its dividend, or through asset sales.
Commercial real estate looks weak...
In its report the Bank of England identifies various areas where new shocks might emerge. Problems could mount in the commercial real estate sector, where price inflation has weakened and a sizeable development pipeline has raised the potential for future over-capacity.
Moreover, there are indications that lenders had already sought to tighten terms in this sector. Many of these concerns are already priced into real estate shares - the sector has already fallen by nearly 30% in the last six months. There are indications that hedge funds closed out some of their short positions in the sector at the end of last month.
Equity prices, meanwhile, have risen strongly, especially in emerging markets in recent months in response to Fed easing. But it is clear that the strength of the FTSE 100 is uneven. Growth stocks have been performing very well, while income stocks have not. The index has an exposure to the fast growing emerging economies and surging commodity prices. Over the last six months the best performing sectors have been oil and gas, mining and mobile telecoms, with returns of 20%, 35% and 44%, respectively. All these sectors make money internationally.
Meanwhile domestic-oriented sectors have underperformed due to problems in the credit markets. Bank shares have taken a hit, commercial property is struggling and higher mortgage and energy costs are eating into household finances. Accordingly, over the last six months the real estate sector is down 29%, and retailers have lost 13%.
As anticipated, this week the Fed cut the Fed funds rate by a further % to 4.5%. This is likely to reinforce the trends in play since mid-August. The major unintended beneficiary of the Fed's recent generosity has been in Latin America. In the two and a half months after the Fed cut its discount rate in mid-August, the MSCI Latin America index was up 44%.
In our early October edition of Fleet Street Letter we highlighted the merits of investing in Brazil. And we believe there is still more mileage here. Brazil's stock market trades at a modest multiple of 17.8 times earnings, making it considerably cheaper than China at 32.6, and India at 26.3 Fed easing will further undermine the US dollar. One of the best hedges against dollar weakness and rising commodity prices is gold, which hit an eight-year high of $799.30 last week.
The bottom line is that the Fed's reaction to difficulties in the US housing market has been to flood the world with liquidity. In this instance, it underpins the boom in emerging markets and commodity prices, while at the same time it weakens the dollar. This has been good news for bullion holders and investors in US multinationals, provided their dollar exposure is hedged.
The message for the FTSE 100 index, meanwhile, is mixed. Real estate sectors, banks and geared retailers will remain unloved in the short term. Moreover, there is a chance that a poor Christmas may bring about a high profile retail casualty (more on this in the next edition of Fleet Street Letter). On the other hand, resource-based stocks should continue to thrive in this phase of financial turbulence, which in our view has not ended.
By Brian Durrant of The Fleet Street Letter.
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