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Contagion or convulsion?

Last week saw the FTSE 100 drop below 6,000 as investors took flight amid fears that the market is going to have a harder landing than anticipated.

The financial markets initially thought the fall-out from the US sub-prime crisis was going to be confined to the credit markets. However, as liquidity has dried up, institutions have been forced to sell blue chips to release capital, which has hit markets hard.

This has prompted the US Federal Reserve and European Central Bank to inject emergency funds into the financial system to rebuild confidence. The Fed has also cut the bank lending rate by 50 basis points.

Scottish Widows Investment Partnership senior economist Sebastian Mackay says the Fed’s actions should provide a fillip to the banking sector.

He says: “Reducing the penalty for borrowing at the discount window reduces the stigma attached and allows banks to use this facility credibly if conditions continue to deteriorate. Having used downside risks to growth to justify the reduction in the discount rate, the Fed can now rationalise a cut in the Fed funds rate, probably at the next meeting.”

But how did the contagion spread so quickly that several markets suffered their worst falls in years?

Hargreaves Lansdown head of research Mark Dampier believes the situation is the result of de-leveraging and likens it to what has happened in the commercial property market recently.

He says: “It is almost a repeat situation, with people running to the exit door to escape. A few have made it out but there are a load of them waiting to leave.”

He says the move to de-leverage will mean that the correction could last a couple of months, with markets continuing to fluctuate in the interim.

“It is going to keep going until the false selling and liquidity issues end. Until then, banks will continue to avoid dealing with one another,” he says.

Lawrence House head of multi-manager funds Alan Stokes thinks the situation could take some time to play out as the extent of the losses suffered by various institutions are still unclear.

However, he says the fundamentals of most companies remain sound, meaning that any blanket sell-off of assets is wrong although it does throw up opportunities for long-term investors.

Stokes says: “Everyone seems to be jumping on the ‘we hate bonds’ bandwagon at the moment but one trap they seem to be falling into is throwing all types of bonds into the same basket. High-yield bonds have not been fantastic but gilts have actually made money in the past few days which has been a rarity in recent times.”

However, some fund managers, such as F&C UK income & growth stalwart Ted Scott, believe this correction may be more serious than that of May last year because consumers will be looking to rebuild their savings due to record levels of indebtedness, particularly if unemployment starts to rise.

Scott has moved his fund to a defensive stance by including the likes of tobacco and utilities, as he expects the market to fall yet further.

The contagion is also being felt further afield. ABN Amro emerging markets strategist Maarten-Jan Bakkum says the credit market turmoil is resulting in a reassessment of expectations for global growth, which is resulting in investors re-evaluating their attitudes to risk.

He says: “What we are seeing is consensus expectations being adjusted. This clearly has an effect on cyclical markets and that means that emerging markets are feeling the pinch. Emerging markets are now being hit doubly, with their currencies also under major pressure.

“As long as currencies continue to slide and the news flow related to the unwinding of the US credit boom continues, global risk appetite is unlikely to recover. For emerging markets, you are also reminded of the classic higher inflation and interest rate risks.”

PSigma equity income manager Bill Mott holds the opposite position to Scott, claiming he is finding a lot of deep value in UK stocks and that large caps look particularly attractive.

Mott says: “We believe that we are working through a financial convulsion which should not lead to a major economic dislocation.”

Schroders chief economist Ken Wade says although around £242bn has been wiped off the value of FTSE 100 shares during the dip, equivalent to a £4,000 loss per person in the UK, the bond and sub-prime markets are shaken but contained, and therefore the global outlook looks fairly bright.

Wade says: “The tightening of credit conditions does not appear severe enough to spark a derailment of the global economy. Market volatility is likely to remain high for the foreseeable future as markets absorb the aftermath of the sell-off but we do not believe there is cause to panic just yet.

“In fact, many of Schroders’ portfolio managers see this as an opportunity to gradually add to good quality holdings at good value prices.”


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