During the summer months, the market’s attention has been on the unfolding story of the US sub-prime mortgage situation and its secondary impact on hedge funds and the collateralised debt obligation market. As we move into autumn, will these issues still be making the headlines or will economic fundamentals start to drive share prices?
It would be surprising if all the bad news on sub-prime defaults has yet been fully absorbed by the market but the ability of new situations to frighten investors is likely to decline. However, while markets may have confronted the bad debt issues, ongoing weakness in the US housing market is likely to continue to cause problems for some companies exposed to the US consumer and this will become more apparent as we move towards Christmas.
These issues have a direct impact on only a few UK companies, which is probably why the stockmarket has retreated only marginally. Meanwhile, the impressive growth rates being enjoyed by China, India and other developing economies are likely to support overall levels of global economic activity. What happens next?
With markets more settled and valuations reasonable, it seems likely that corporate results will drive prices. Recent company releases have generally been supportive for further advances in the market but there are several reasons to fear that some future outlook statements may not be so confident. The poor summer weather will have affected some UK companies, such as pub stocks, and the slowing in the UK housing market must surely hold back the consumer names.
The ongoing decline in the dollar is limiting profit growth for many companies and at some stage we will see analysts downgrading their expectations for financial companies exposed to the US sub-prime, CDO and fixed-income markets. But many capital goods companies are enjoying buoyant trading due to strong investment levels in the Far and Middle East, and this is highly unlikely to have been disrupted by events in the US.
Over the next few months, we will be taking a particular interest in corporate activity. Takeover bids have been a very positive feature for the UK stockmarket in recent years, driven in large part by private equity firms bidding for quoted companies. Many private equity firms have been able to raise substantial sums for new funds but they usually need to gear up their investments to achieve their desired equity returns. Corporate debt markets have been badly affected by the sub-prime crisis and look likely to be closed to the private equity industry.
The cost of borrowing will certainly be higher than anticipated when the debt markets return to a more normal condition. However, if conditions ease and private equity bids restart, this will be an undoubted positive for the market.
Another reason for paying close attention to takeover activity is that it can be a good indicator of corporate confidence. If this has been damaged by recent events in the US, we are unlikely to see companies bidding for each other. As well as bid activity from the private equity sector, there has been a steady stream of corporate buyers, particularly from overseas. If companies can see that recent market turmoil is indicative of more difficult trading conditions in 2008, then we are unlikely to see them issuing equity to buy their competitors.
Our best guess is that many companies will still be keen to participate in consolidation at the right price and the economic outlook will not have deteriorated sufficiently to put them off acquisitions.
There is a danger that we are being too relaxed about the secondary effects of the US debt crisis. Over the years, we seem to have had several geopolitical and financial crises that have challenged investor confidence, yet on nearly all occasions these have proved to be buying opportunities. But a credit and liquidity crunch will have frightened investors and the rest of the year will prove whether this summer was a minor storm or the start of something more serious.
Stuart Fowler is senior equities fund manager at Axa Investment Managers