Pegasus View October 2007
By Yvonne Staples
We are now in the forth quarter following a volatile summer in financial markets. Across the world, banks found themselves holding billions of US dollars worth of structured bond products related to borrowers with poor credit histories known as the US sub-prime market which lead to the recent “liquidity squeeze”.
After a period of low interest rates and a global surge in demand for property, prices soared in most of the western world. Banks were happy to lend to individuals with questionable financial history as they were confident that even if they could not meet the mortgage repayments they could sell the house very easily (at a profit) and repay the mortgage.
Banks then packaged the mortgages up into residential mortgage backed securities (RMBS) or Collateralised Debt Obligations (CDO’s) and sold them on. Ratings agencies then rated these instruments and, as they were being issued by large US Banks, gave them top ratings which meant banks all over the world were quite happy to buy them. The problem now is that no bank really knows how much sub-prime debt they actually hold! This is what has unsettled the stock markets (financial stocks have been hit worst than most) and led to banks wishing to keep hold of as much of their cash as they can.
Because banks were keeping their own cash they were not lending it to other institutions and hence the term ‘liquidity freeze’ (or “credit crunch”). Most banks take customers’ deposits and then lend that money to other customers as mortgages, at a higher rate in order to make a profit. Northern Rock, a FTSE 100 company, however did things a little differently and went to the market (other banks) for cash and then offered mortgages. Because other banks became unwilling to lend money, Northern Rock had to ask the Bank of England for a cash injection and the result is its share price has fallen some 70%.
There is inevitably more bad news to come from the sub-prime markets with the US housing downturn continuing which will slow GDP growth in the region next year. This will, however, be partially offset by the beneficial effects of the weaker dollar and the knowledge that the Fed has the capacity to cut rates further if required to boost confidence.
European economies have also begun to slow down affected by high energy prices, rising interest rates and a strong Euro. Fortunately economic growth remains strong in China and India and therefore the risk of a global economic recession seems relatively low.
The emergence of the Chinese economy is the biggest economic event of this decade, with the Hang Seng Index now up 50% over the last year. Many of the managers we have met believe that these markets will be subject to increased volatility and there could be a correction due, although the widely accepted view is that over the long term China will see significant growth.
A spin off of the China story is that of Africa. Many African economies may benefit not only from direct investment from China itself (Industrial and Commercial Bank of China’s (ICBC) recent acquisition of a 20% stake in Standard Bank) but also because of the increased demand from China (and India) for commodities and natural resources that Africa has in abundance.
A positive factor that cannot be forgotten in times of volatility is that equity valuations are reasonable and we are nowhere near the level of overvaluation that might indicate a major market top. The S&P 500 is trading on 15.45x earnings for 2007 and 13.6x for 2008. The DJ Euro Stoxx 50 is trading on 12x earnings for 2007 and 11.1x for 2008.
In conclusion, we believe that the global equity bull market, whilst mature, remains intact. Despite rising risks of volatility in the very short term (1-6 months), we remain equity market positive.