| INVESTMENT REVIEW FIRST QUARTER 2008
The first quarter of 2008 saw equity investors’ nerve finally crack and markets fell across the globe. The probability of a US recession increased, inflation remained stubbornly high and the painful discovery process amongst financial firms of their problematic US sub-prime mortgage assets continued.
In the US, the epicentre of the global credit problems, the Federal Reserve is determined not to make the mistakes of the early 1930s. It took aggressive action to free up the banks’ balance sheets, providing large amounts of funds to banks. In exchange it took secured assets that, whilst not apparently impaired, were not tradable in the inter-bank market. Critically, the rates charged to banks on these asset exchanges were reduced, although the stigma of approaching the central bank remained. Of course the accompanying, more conventional, policy responses were the successive cutting of the Fed funds rate from 4.5% to 3% over the quarter and the $160bn tax stimulus package. The tax stimulus should hit US consumers’ pockets towards the end of this year.
Notwithstanding these moves, the underlying economic data continues to deteriorate. US housing and retail statistics worsened, although US exporters were cheered by the falling Dollar. The weaker dollar is a function not just of the rapidly falling US interest rates, but also investors’ inflationary concerns that the Federal Reserve might ultimately try to reflate the economy out of trouble by creating new money. Gold burnished its “store of value” credentials, rising 10% over the quarter to new all-time highs.
The transmission of problems to Europe was all too visible. UK consumers are even more indebted than their US counterparts and finally lost confidence as concerns mounted over future economic prospects. The Bank of England begrudgingly conceded a further 25 basis point cut to bring rates to 5.25%, but resisted pressure to provide a large scale US-style liquidity package to the moribund financial sector. The net result was that, whilst UK interest rates have fallen 50 basis points since last summer, loan pricing to corporate and retail customers actually increased. This is because banks have sought to increase margins to alleviate pressure on capital after the harrowing losses reported in 2007.
Inflation remained an issue. Oil, food and metals prices moved ever higher and the Eurozone economies – large importers of oil and metals - found themselves being denied cuts in interest rates as the European Central Bank tried to contain the burgeoning price pressures. The product of the strong stance on inflation was a 10% appreciation in the Euro against both the US Dollar and Sterling – all time highs which are likely to depress Eurozone exporters’ profits.
Bond markets, too, reacted to the worsening data. Yields on 1st world sovereign debt fell, as investors sought safety and recessionary pressures built up. Credit risk, however, left corporate bonds at elevated yields and sentiment was sufficiently negative to extend counterparty risk to government bonds. The Italian 10 year bond experienced trading at 0.5% yield premium to its German equivalent as at quarter end – an unprecedented spread in the history of the Euro.
Japanese equity performance disappointed, with exporters being similarly affected by the 10% Yen / US Dollar appreciation over the quarter. Other Asian equity markets suffered severe pullbacks too – China and India’s equity markets both fell over 20% - but the enthusiasm for the commodity investment themes driven by their industrialisation remained intact. It is likely that much of the strength seen here was the result of short term speculation and investors switching from the other underperforming asset classes of equities, property and US sub-prime exposed hedge funds.
April 2008
(Data source: Bloomberg) - All returns in local currency terms
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