[image 1] The Bank of England’s move to support the ailing Northern Rock with hard cash, in order to underpin confidence in the financial sector, may yet have implications for the wider market. Simon Ward, economist at New Star Asset Management, argues that “Other assets” on the Bank of England’s balance sheet rose by a further £2.3 billion in the week to Wednesday 10 October, bringing the total increase since the run on Northern Rock started to £12.9 billion. This is the best available estimate of the extent of the Bank’s support to the troubled mortgage lender.’

He adds, ‘The Bank of England’s injection of funds into Northern Rock has contributed to an easing of money market conditions in recent weeks. Northern Rock has used the funds advanced by the Bank at a penalty rate to repay its retail depositors and other creditors. Rather than stash cash under the mattress, these customers have mostly redeposited their savings with other banks and building societies, which have, thereby, enjoyed an infusion of liquidity without having to pay the Bank’s penalty rate for emergency borrowing.’

Free money

Ward points out that ‘In effect, Northern Rock’s shareholders have paid the penalty demanded by the Bank to supply the banking system as a whole with greater liquidity. More controversially, it could be argued that the current structure of incentives has created another form of “moral hazard”. By refusing to lend to Northern Rock, other banks have forced the Bank to supply additional liquidity, which they have been able to access at non-penalty rates.’

Colin McLean, managing director of SVM Asset Management, picks up this theme: ‘There are previous examples of bank problems, financial lifeboats and restructuring but, surprisingly, companies like Railtrack and Rover might be better indicators of the future of Northern Rock. Both were effectively taken under political control while still listed on the stock market.’

He points out that ‘The “moral hazard” of using public money where private gain may be involved looms large in policy. Analysts were slow to recognise the political difficulty a share dividend would cause, but soon other issues, ranging from terms of any continuing lending to directors’ pay, were picked up by the press. When so much public money is involved, do politicians really want the same bank management to handle that? Remaining open for “business as usual” and actually doing business are different things. A high degree of regulatory control is likely behind the scenes.’

McLean concludes, ‘As Railtrack showed, the longer politicians and authorities are involved, the more danger that shareholders or staff will rely on assurances or seek compensation on any adverse outcome. This is the drawback of intervention, and politicians clearly benefit from an early solution.’

Equities up again

Looking more broadly, John Kennedy, portfolio manager at The Scottish Investment Trust, says, ‘Amidst September’s turmoil, it is easy to overlook the fact that equity markets rose over the month. The global FTSE All-World Index rose by 4.2 per cent in September, taking the 12-month capital return to 12.0 per cent. While so-called “developed” markets were suffering from the ongoing credit crisis emanating from a rise in defaults in risky US mortgages, the stock markets of Latin America and Asia Pacific (ex Japan), most notably India and China, were completely unruffled by such concerns and powered on to new all-time highs during the month, with double-digit percentage increases in September alone.’

Kennedy argues that ‘Within Asia Pacific (ex Japan), the stock markets of high growth China and India have been explosive, reaching all-time highs and, in China at least, there are worrying signs of abnormal optimism and extreme valuations in the mainland stock market. This has pulled up Hong Kong-listed China-linked stocks and other regional markets in its wake.’

A mixed bag

James Thomson, manager of the Rathbone Global Opportunities fund, feels that ‘The late summer panic subsided in September and equity markets staged a strong recovery. Major banks across the world went some way in quantifying their exposures to the sub-prime arena and illiquid credit markets, providing greater certainty for investors.

‘Over the past three months, I visited more than 60 companies in Japan, Germany and the US. It would be convenient to summarise the outlook in a single sentence, but that is not realistic.

The investment environment comprises a wide variety of microclimates: some are experiencing higher levels of demand and pricing power; some express confidence but do not have the greatest of visibility; and others are wallowing in a pit of despair. As ever, it is our job to continue to distinguish between these characteristics and steer the fund through what could remain a fragile time for investors.’

Anticipating US earnings

Turning specifically to the US, Kully Samra, branch director of Charles Schwab, U.K., notes, ‘We have seen the S&P 500 hit historically high levels recently, which means the price to earnings ratio through Q2 earnings is at 17.0. Over the past few years the range has been between 16 and 17, but inflation was always higher during this time, so one could argue that the current market valuation is a bit low.’

He adds, ‘With the US earnings season getting into full swing, forecasts for third-quarter growth are for about two to three per cent over the third quarter of 2006. This number has not been reduced, even by the fallout at the banks from the sub-prime issue, as most of the items are being counted as one-time charges.’

However, Samra cautions, ‘For the final quarter, earnings expectations are for ten per cent growth, in part due to easier comparisons as energy companies’ earnings slowed last year. Forecasts are also for ten per cent growth for the first half of 2008. But this will be difficult to achieve if economic growth is sluggish, and the cut in US rates doesn’t totally eliminate recession risk. So while valuations are reasonable, and earnings growth looks okay, it may be important to exercise caution as we see what happens over the coming months.’

Key indicator

INDIA – Exports (1 November)
The export data will be viewed with interest. Recent strengthening of the rupee has caused concern over the impact that such currency gains will have on India’s export market, underlined by Indian trade minister Kamal Nath. The rupee has been the best-performing currency in Asia in 2007, and while some measures have been taken to try and curb the rupee’s quickening appreciation, it is clear that further steps need to be taken to ensure the export market is protected. Indian exports are down ten per cent so far this year and further measures are needed to protect India’s competitiveness. Nevertheless India remains the second-fastest growing major economy after China. Source: Gartmore

MEXICO – Consumer confidence (7 November)
Heightened volatility over the summer months due to the US sub-prime mortgage crisis has had a negative impact on Mexico’s economy. In 2006, more than 80 per cent of Mexican exports were consumed by the US. In the second quarter, the pace of growth picked up in Mexico in response to demand in the US. Now, remittances from Mexicans in the US have slowed down and growth has been moderate when compared with other Latin American countries. Consumer confidence peaked in July but fell back significantly in September. In the latter part of 2007, economists will be looking for evidence of how far Mexico has been affected by the US downturn.
Source: Gartmore

This article is from the November 2007 issue of What Investment.