Pegasus View Quarter 1 2008
January 2008 was the worst start to Investment markets since 1935 some commentators suggested. The view that the US would enter, or was already in, recession combined with the collapse of the US housing market and the sub- prime mortgage market and resulting credit crisis were the main reasons for this. Things got considerably worse in late January when a trader at SG Hambros ran up billions of dollars of losses and the attempts to unwind these positions prompted highly volatile market trading, which in turn prompted the US Federal reserve to cut interest rates by 0.75%. Add to this the emergency rescue of Bear Stearns by JP Morgan Chase, who initially paid $2 per share for a stock that was trading at $147 a share a year earlier, and it is easy to see why markets got spooked! The news that the price was raised from $2 to $10 was received well by the markets.
US Recession:
There is little doubt that activity has slowed and this may show that the US is in recession. As markets are discounting mechanisms, they are more concerned by how prolonged this recession will be. The news in Q1 08 was not encouraging, with unemployment rising and the service sector contracting and there has been an alarming fall in the value of people’s homes. The plus side however, is that the US Federal Reserve (Fed) has been very decisive and interest rates were cut in 2007 from 5.25% to 4.25% at year end, and have been lowered further to 2% this year. In addition, the Government has put measures in place to ensure that home owners have more time to make alternative loan arrangements and avoid having their houses repossessed. Domestic weakness has been partially offset by increased exports due to the weaker dollar and there are tax breaks in place this summer that will give the consumer more money to spend; this should bring the economy out of any recession.
So where does the UK stand?
The UK has a lot of similarities to the US, in so far as their consumers are heavily indebted (reliant on their homes rising in value) and the economy is heavily geared towards the Financial Sector, which will slow considerably this year and most likely result in thousands of job losses. The Monetary Policy Committee (MPC) has been a lot slower to react than its US counterpart and seems more concerned with keeping inflation under control. This has resulted in Interest rates being cut by only 0.25% over the quarter. Inflation appears to be under control. Of the Managers we met this quarter, their expectations for UK interest rates in 12 months time range from 3.5 - 4%.
Europe has done reasonably well as the US and UK problems are not as prevalent, largely due to low home ownership (Spain and Ireland aside) and the ECB has not as yet signalled that it is considering reducing Interest rates just yet. On the back of this, the Euro has been very strong versus most major currencies. Again, the managers we spoke to expect this situation to change as a strong Euro will hurt Europe’s exports over time.
Credit Crisis:
This topic has been widely covered in the media over the last 9 months or so, but it is a theme that may run for some time yet. Simply, financial institutions have been reluctant to lend money to one another until they can be sure what exposure they have to Sub-Prime mortgages. This has resulted in the London Inter Bank Overnight Rate spread (LIBOR) moving from its usual 0.2% above base rate to nearly 1% above. This has been mirrored in the USA and Europe, resulting in the relevant central banks taking these sub-prime assets from financial institutions and providing cash in return so that they will begin lending again. This has helped but as yet has not solved the problem. The net result is that banks across Europe and the US have removed a lot of mortgage deals and changed their lending criteria. Some mortgage brokers have gone out of business as a result.
Commodities:
Commodities have also been in the news this year, with the oil price hitting the psychological $100 mark and well beyond, largely due to the fact that OPEC are reluctant to increase supply with the demand from India and China showing no signs of easing. Gold breached $1000; this is largely due to the fact that Gold historically has been strong when the Dollar has been weak. In the main the managers we have met have been selling their Gold holdings above $1000.
Soft Commodities have been, and remain, a key part of our preferred manager’s portfolios.
Outlook:
Of the five Investment Managers we met at quarter end, they are all mainly bullish about the rest of the year. They expect the volatility to remain over both this second quarter and perhaps the next, but once the data begins to show that a recovery is under way Quarter 4 should be a profitable one. (It usually is when there is an election is the US!) With this in mind they have begun increasing their exposure to equity markets with the US being their preferred area for now, with two managers even buying US home Builders. They have nearly all been buying the dollar as they expect it to be strong versus the Euro and Pound until year end.