Chartwells View on Market Falls

The market falls that we covered in our email bulletin two weeks ago have continued – making their way into mainstream news headlines.  Indeed it is likely that most people who follow current events will be aware of the concern surrounding the sub-prime mortgage sector in the US.  The fact that this concern has now spread to investors, who are unsure as to the extent of the problem - and central banks, who have begun to pump money into the banking system to shore-up investment funds – all adds to the newsworthiness of the story and some alarmist headlines.  So should we be worried?

We believe that there is no sign that the current credit crisis will cause an overall global economic slowdown; and view the fundamentals underlying the global economy as good.  We see the current events as being largely anticipated; and not the start of the prolonged sell-off of equities (or bear market).

For several months now, analysts have been concerned about who was going to end up holding the debt issued by the sub-prime mortgage lenders in the States.  If there’s one thing that the market dislikes more than anything, it’s uncertainty; and stockmarkets have reacted accordingly.

Furthermore, there has been a growing awareness that the availability of cheap money (i.e. the ability to borrow at a low interest rate) was running dry as interest rates around the world were on the increase and lenders become more circumspect as to whom they lend to.  Much of the rise in equity valuations over the last 18 months has been fuelled by speculation based on the possibility of merger and acquisition (M&A) activity – made possible by the ability of private equity companies and others to borrow cheaply to fund their buyouts (known as leveraging up).  Consequently, investors’ appetite for possible M&A targets (which has been just about anyone) has rescinded.

Economic growth remains robust in Asia and steady in the UK; although the latest data this week from France, Italy and Germany was slightly below expectations, the consensus surrounding Europe as a whole is positive for GDP (Gross Domestic Product) growth this year.  As we’ve covered in previous commentary, corporate earnings growth is heartening globally (even in the US).

Yes, the US economy has slowed; and yes, the US consumer will probably have to stop spending so much; but the traditional relationship between the US consumer and Asia (in particular) is changing.  Asian exporters are increasingly selling their goods to other Asian countries; and China itself has a rapidly developing domestic market.  Recent data from the US also supports the view that growth could pick-up later in the year.

The last few weeks have seen a ‘flight to quality’, with investors rushing to strongly rated government bonds in the UK, US and Japan.  In the near term, we expect to see this risk aversion move in favour of the so called ‘mega-caps’ (e.g. the top 10-20 companies in the FTSE 100 Index, by way of market capitalisation).  Such ‘mega-caps’ generally have strong balance sheets and often pay a good dividend – making them a natural haven in times of uncertainty.

Our view has always been that stock markets will be volatile; and this year we have seen similar volatility in the bond market – emphasising the importance of having a truly diversified investment approach that includes assets whose returns aren’t well correlated to equities or bonds – such as property, commodities, derivatives, structured products, hedge funds and cash.

Ultimately, the biggest losers in the credit crises might be the credit rating agencies that assess how risky a particular issue of debt is (i.e. put simply, the chances that the debtor will default).  There are accusations, which are being echoed by some governments and regulators, that there could be a conflict of interest when they rate debt.  The reason for this is that they are paid for their rating service by the banks who issue the debt.  Not only was there a delay in US banks reporting poor returns from the sub-prime mortgage sector, but even after higher defaults were reported, credit agencies continued to support debt trading at a discount.  Expect, at the very least, a strengthening in the code of conduct here, if not full scale enquiries in the US and Europe.

[Source: BBC Online, Financial Times, Reuters, Forbes.com, Midas Capital, Gartmore, PSigma Investment Management]