October 2007

Markets are climbing a wall of worry with interest rate cuts now firmly on investors’ minds. How swiftly macro economic perceptions have changed : only a few months ago further rate rises were close to certain and banking stocks (having been heavily sold down) now look well placed for some outperformance in the last quarter of the year.

It was probably inevitable that at some point, punters would get stuck into these stocks where 6.5% dividend yields and single digit earnings multiples across the sector are the norm. We need to be careful however and let us hope that another Northen Rock isn’t lurking in the shadows; clouds do still remain across the credit markets.

The ongoing weakness in the US housing market and the potential negative economic consequences of the tightening in credit conditions ultimately led to Ben Bernanke (Chairman of the US Federal Reserve Bank) cutting both the base rate and discount rate (again) in September. Whilst some might argue this was perhaps a case of ‘better late than never’, it has given equity and commodity markets a shot in the arm. This has obviously been most welcome as investors will naturally have seen an appreciation in the value of their stock market interests.

The real motivation behind this monetary easing was however designed to alleviate the high rates of interest banks are charging to lend to each other and the associated general tightening up of liquidity flows. Ordinarily this inter bank rate should sit only marginally above the base rate but a wide spread between the two still exists. Accordingly some feel markets have perhaps got a bit ahead of themselves currently and some caution is required at current levels. I concur with this view.

There is a growing concern that the lasting legacy of the credit crisis will be economic slowdown both in the US and the UK. Likewise there is an increasing expectation that (further) interest rate cuts will be required to head off the possibility of recession or stagflation (where inflation exists but with no underlying economic growth). How quickly perceptions change in the markets. Only a few of months ago, interest rates here in the UK were going to 6% minimum as inflationary pressure continued. Now, what started as a sub prime lending problem in the US has left us facing very real prospects of a corporate slowdown.

Banking stocks have started to rebound as investors are starting to believe that valuations have fallen too far. Naturally these stocks have been avoided in the recent past through concerns relating to possible (sizeable) exposures to US subprime and possible earnings reductions not helped by the day to day impact of the squeeze in credit. To the extent that the worst is hopefully behind us, stock pickers are looking forward to improving conditions in the banking arena. Portfolio managers could now be switching out of telecom and mining stocks which have traded strongly through the recent volatile times.

The current general underlying assumption is that the UK and US economies will not hit hard times just a slowing in economic activity. Mervyn King and the Bank of England cannot afford to make a mistake with monetary policy further to the heavy criticism recently received reference their handling of the Northern Rock debacle.