Market commentary - October 2008

Market commentary - for the period April 2008 to October 2008


UK Equities

(FTSE All Share Index -16.2%)

The summer of 2008 has brought scarcely believable events almost every day and increased the volatility of financial markets beyond most conventional measures. This review is too short to encapsulate all of the ramifications of the past six months (there will be plenty of books) suffice to say that the investment team at IFPC are available to discuss any further questions that you may have. The financial markets are in the process of de-leveraging (reducing the level of borrowing in the financial system) and this has resulted in the forced selling of good quality assets by investment managers in order to meet their outstanding obligations. Foreign governments are selling their overseas assets to repatriate funds to support their own domestic institutions, hedge funds are unwinding positions in lieu of client redemptions and significant damage has been caused by the collapse of Lehman Brothers, the U.S. investment bank.

UK banks are recapitalising by rebuilding their deposit base and reducing the size of their loan books to improve the quality of the assets they own. Lending standards are tightening and small to medium sized business in particular are struggling for credit. In an historic move, the UK Government said it would inject £37 billion of new capital into Royal Bank of Scotland (RBS), Lloyds TSB and HBOS in a part nationalisation and in return, the Government will expect a more austere dividend policy.

At the heart of the financial system and rarely observed by the public, overnight lending between banks represented by LIBOR (the London Interbank Offer Rate) has virtually ground to a halt as fear of further banking failures has resulted in banks hoarding cash. The Bank of England has cut interest rates by 0.5% and has allowed banks to use lower quality assets as security for borrowing directly from the Bank of England. There are tentative signs that these measures are working and the return to a properly functioning banking system is an important building block to a market recovery.

In the real economy, the UK will enter a recession during 2009 with negative growth forecast for the next two quarters at least. Inflation is forecast to peak by the fourth quarter of this year and is likely to fall considerably over the next year due to the dramatic fall in the oil price from over $150 dollars a barrel to below $70 a barrel. Indeed, this should create the conditions for further interest rates cuts. The UK stock market is currently trading at valuations not seen for a generation and does indicate considerable value over the long term for investors willing to see through the current volatility. However, markets tend to overshoot on the downside and it is likely that we will see continued volatility for some months to come before we can decipher the true position of the economy.

International Equities (FTSE World ex.UK Index -14%)

In the United States, the government announced a revised Emergency Economic Stabilization Act (EESA) allowing it to invest US$250 billion in nine institutions which it has effectively identified as being too large to fail. The S & P 500 index, which is a broad measure of the U.S. stock market, fell by
-18.69% although the translation of these investment returns back into sterling was cushioned by an 11% appreciation of the dollar against sterling.

In Europe, the FTSE Eurotop 300 index fell by -18.05% during the period whilst the European Central Bank (ECB) cut interest rates by 0.5% in October, it’s first cut since June 2003. Meanwhile, Germany, France, Italy and Spain appear to be on the brink of recession after business confidence surveys hit multi year lows, whilst Ireland entered recession for the first time in 25 years after it’s economy shrank in the second quarter of 2008. The Euro weakened slightly by just under 2% against the pound but weakened significantly against the US$ by 14% providing some joy to European exporters.

In Japan, the Nikkei 225 index fell by -21.16% as growth in the economy slowed markedly. Rising energy costs, weak exports and low inflation are creating problems in the short term. Japanese banks unburdened by sub prime loans are becoming aggressive buyers of cheap global assets as they aim to avoid stagnating domestic growth. The pound weakened against the Yen by 12.46% during the period providing positive currency benefits for our Japanese investments.

In the Asia Pacific region, the benchmark MSCI Far East (excluding Japan) Index fell -31.66% during the period due to high company valuations, lower forecasted profits and the slowing of global economic growth. Hong Kong, Australia and Singapore continue to offer opportunities whilst China’s growth is forecast to slow down to a still eye watering 9% in 2009.

In emerging markets, the severe drop in commodity prices has put substantial pressures on previously robust economies as the benchmark index has dropped by -36%. There are now widespread fears of emerging market governments defaulting on their debt obligations particularly in Argentina and Venezuela whilst the financial position for the Ukraine in Eastern Europe is looking precarious. India should weather the storm although company valuations still need to rebase.

Fixed Interest (FTSE British Govt All Stocks Index +3%)

UK Government bonds have benefited from the ‘fight to quality’ by investment managers looking to park their assets in a safe place in times of turmoil. The key question for fixed income managers allocating money will be ‘is the UK economy entering a period of deflation or inflation?’ The answer is probably both. As the oil price drops, inflation is likely to recede and a recession will likely produce deflationary conditions i.e. a sustained drop in the price of goods and services. However, as interest rates are reduced over the next year or so and growth resumes in the economy, inflationary pressures may reappear as the money supply is increased.

The corporate bond market can best be described as dysfunctional with poor liquidity (ability to buy and sell investments immediately) a severe problem. Investment grade bonds i.e. borrowing by large companies with good credit records now offer interest rates that are approximately 5% above the yield on US Treasury securities. These rate differentials were last seen in the 1930’s and indicate that corporate bonds are either tremendously undervalued and will provide substantial returns over the coming years or that we are entering a recession of the like we have not seen for over seventy years. The consensus opinion favours the former at the present time but this statistic does indicate how stressed the debt markets have become. Companies defaulting on their debt obligations are likely to rise substantially over the next year or so.

Commercial Property (FTSE All UK Property Index -8.5%)

It has been another poor period for the UK commercial property asset class and we continue to see further write downs of net asset values. Landlords are being pressured to offer monthly rental payment facilities to their tenants as the current quarterly payment system is creating cash flow problems. Yields appear to be rising but commercial pressures will force tenants to renegotiate more favourable rents in a downturn.

Alternative Investments (FTSE Hedge Sterling Daily Index -12.8%)

The global market for hedge funds has suffered it’s poorest year for some time. The failure of Lehman Brothers created a huge unwinding of sophisticated contracts held by hedge fund managers and lending rates charged by the banks rose sharply. The part nationalisation of the banks both in Europe and the U.S. wiped out potentially profitable positions as did plummeting commodity prices. As institutions have sacked their hedge fund managers, the funds have been forced to sell their assets at knock down prices to market makers who saw them coming. It is these conditions in particular that many attribute to the equity market volatility in October.


IFPC is authorised and regulated by the Financial Services Authority

Source of statistics: Lipper Hindsight, Sharescope Alpha

Disclaimer: this document represents investment commentary of a general nature and should not be used as a basis for making personal investment recommendations. It does not take into account personal investment objectives and you should contact an adviser at IFPC if you require further financial advice.

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