The Bank of England’s Monetary Policy Committee (MPC) shaved a further 25 basis points (0.25 per cent) off base rates on 10 March, and the economists were quick to comment.

Most felt that the MPC will have to go further. Peter Hensman of Newton Investment Management felt that ‘The Bank of England cut interest rates as expected, as the continued effects of the credit crunch mean that concerns about the downside risks to growth outweigh current price pressures.’

But he added, ‘Given that the reduction in credit availability is a function of the loss of confidence among financial institutions, a quarter-point interest rate cut is unlikely to have a significant impact on the challenging outlook for the domestic economy, especially as lenders will use this rate cut to improve profit margins and hence are unlikely to fully pass on the rate cut to households. Further rate cuts and sterling weakness are likely.’

Running to stand still
Catherine Macleod, economist at BDO Stoy Hayward Investment Management, observed that ‘Basically, the Bank of England is running to stand still. The reason lies in the international banking crisis. It is increasingly expensive for banks to borrow from one another and, rather than swallowing the increased costs, they are passing them on to consumers.’

She adds, ‘With its fixed inflation target and rising inflation expectations, the Bank of England is facing a tougher trade-off than the Fed, which has a dual growth/inflation mandate, and we expect it will not be able to ease rates as aggressively as its US counterpart. But such easing is necessary. Although there is public resentment at the bailing out of rich bankers and the aggressive cuts, higher inflation expectations are likely. To do nothing is likely the graver error.’

Chris Iggo, senior strategist, UK, at AXA Investment Managers, points out that ‘The MPC said that the availability of credit was worsening – but it has not yet shown any willingness to do anything about this. Further rates cuts are needed, and so is action on liquidity. The Bank had to expand its balance sheet to rescue Northern Rock, and there may be an unwillingness to offer additional lending to other institutions. However, if nothing further is done to address liquidity concerns, the risk is a much weaker economy and another financial victim.’

Towards recession
For Ted Scott, manager of the F&C UK Growth & Income Fund, ‘The MPC, which has been carefully balancing inflation concerns against a slowdown in growth, is clearly very worried about the economic outlook, and it is also possible that they know something that the rest of us do not. Certainly, the chancellor’s recent forecasts appear to have been way too optimistic.’

He adds, ‘Disposable income is really being squeezed and, in my view,
a recession is becoming increasingly likely. This is being mirrored in the exchange rate. For some time, we have positioned the F&C UK Growth & Income Fund very underweight domestic consumer-facing stocks and we will continue to do so. We also remain underweight domestic banks, though some exposure is necessary
to harness yield.’

The reassuring aspect, however, is that so many UK companies now conduct a lot of their business overseas. Scott concludes, ‘We are able to find opportunities that are relatively less exposed to the deteriorating UK economy while staying within the remit of the fund, particularly in the FTSE 100 and the commodities sector.’

Market falls
Rebecca Chesworth, UK equity investment specialist at Threadneedle Investments, points out that ‘The past three months have seen the worst quarterly return for UK equities for almost six years. In sector terms, the biggest falls have been in consumer services – retail and leisure – and telecommunications, while mining, oil services and industrials, and real estate have held up relatively well.’

She reports, ‘We have not identified the turning point yet, but are certainly looking for it. Meanwhile, we remain positive over the longer term, seeing support from attractive valuations, particularly dividend yields, and the financial health of UK Plc. We expect the return of M&A and more activity from the sovereign wealth funds.’
 
Vive la difference
Tom Elliott, global strategist at JPMorgan Asset Management observes that ‘On the face of it, the predicaments for the European Central Bank (ECB) and Bank of England look similar. Both have to keep a careful watch on inflation, while at the same time the underlying economies are slowing. Interest rates in both regions are far higher than the US and Japan.’

However, he adds, ‘Looking a little more closely, different forces seem to be at work. This has been indicated by central bank rhetoric, with the Bank of England appearing to be more concerned about the economic impact of credit stress than its continental counterpart. The currency markets have taken a very different stance towards the two regions. The euro has strongly appreciated in recent months, while sterling’s performance has been, well, less than sterling. Interestingly, headline inflation in the eurozone is also running almost one per cent higher than in the UK, despite the strong euro.’

Kevin Lilley, manager of the Royal London European Growth Trust, reports that his fund is adopting a defensive stance: ‘In recent weeks, a number of market commentators have been suggesting that equity markets are forming a bottom. While there have been a number of market-friendly actions from the US and other central banks, it is difficult for me to see that a bottom is in sight, until US house prices have found a floor and stockbrokers’ analysts become far more realistic with their estimates.’

He adds, ‘In the Royal London European Growth Trust, I retain a defensive stance in anticipation of worse economic news to come. The fund has a ten per cent underweighting in financial stocks, which I believe remain exposed to further losses as a result of the global credit crunch. The fund has a similar position in industrial stocks, reflecting my belief that slowing economic growth, foreign currency headwinds and rising costs will lead to a cyclical fall in profitability. The fund is five per cent overweight in oil and gas, where I believe fundamental supply and demand issues will continue to provide support.’

Rescue package
As for the US, some fund managers see the rescue mission for borrowers being proposed by politicians and regulators as a positive move. Marsico Capital Management’s Cory Gilchrist, who manages Gartmore’s US Opportunities Fund, asserts, ‘We feel that it is extremely important that the government craft a viable and meaningful plan, which will put a floor underneath the ailing housing market to allow a recovery to take hold.’

The significance of these moves for the US economy is that ‘Visible signs of a stabilising housing market could have an important positive impact on consumer and business confidence, lending activity and economic growth. If that scenario were to unfold, areas such as consumer discretionary and financial services could become quite attractive from an investment perspective.’

Value in growth
And through all this turmoil, the emerging markets continue to deliver growth. Indeed, the effects of a global reversal in markets mean that equities in many emerging markets now look extremely cheap.

Ece Ugurtas, manager of the Baring Emerging Market Income Fund, suggests that ‘Domestic demand within Asia remains robust and, despite current volatility, we believe companies are well positioned to benefit from domestically generated robust economic growth, and that share price valuations remain attractive. We are confident of the potential for emerging market equities and are prepared to add to our equity allocation on further weakness.’

He adds, ‘Higher soft and hard raw material prices may be hurting Western consumers, but on the other side of the world, emerging market exporters are big beneficiaries. Secondly, huge infrastructure investment is required to match the pace of demand across the emerging markets, particularly in the areas of power and transport. Thirdly, investors should be looking for internal consumer-driven growth stories in the emerging economies rather than at their Western-orientated export companies.’