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MONEY MARKETING MARKETS: Banking on gloom?

Banks have been the watchword of the week with the Bank of England’s dour warning on the outlook for the economy and Bradford and Bingley’s worse than expected writedowns rubbing out the FTSE 100’s gains earlier in the week.

By mid-afternoon Friday, the FTSE was trading at 5,792, only 20 points above broadly flat on where it started the week.

The Bank’s latest quarterly inflation report, a key indicator of future interest rate policy, did not help market confidence.

Although it revealed that consumer price index inflation was broadly in line with targets at 2.1 per cent in December, Mervyn King soured the message by ruling out further aggressive rate cuts amid concerns about the inflationary pressures of rising fuel, food and import costs.

King also painted a picture of low economic growth and said it was “more likely than not” that inflation will soar above 3 per cent over the next two years, restricting further rate rises and forcing him to write another letter of explanation to the Chancellor.

The market had been anticipating four rate rises by next March, but King says this would cause inflation to undershoot the target, prompting many fund managers and economists to revise expectations to just two rate cuts.

The Bank also pointed to weakening consumer demand and business expenditure, warning recession is possible, albeit likely to be mild.

However, Max King, manager of the Investec managed growth fund, believes the Bank may have over-egged the inflation pudding.

He says: “I think the UK economy is going to be even weaker than the Bank expects, which should take some heat out of inflation. The economy is slowing and employment prospects are not great, which will reduce wage pressures.”

Lawrence House fund manager Alan Stokes also expects fuel prices to dip in the summer, pointing to the fact that many energy firms work on three-month contracts, which will be renewed at more favourable prices.

But the Bank’s fears that weakness in the credit markets could hamper growth proved prescient as Bradford & Bingley reported much larger than expected writedowns.

B&B has been the first bank to report and unveiled writedowns of £225.6m, which halved its 2007 profits.

The company’s shares fell 23 per cent on the news from 243p to 187p and after a further slide today are now at 177p, their lowest ever price since it floated eight years ago at 248p.

“The figures were shocking and much worse than expected. It will be interesting to see the numbers from the major high street banks,” Stokes says.

They must be bracing themselves and Stokes says how far they fall on the news will reflect how close to a bottom the sector is perceived to be.

Since B&B’s Wednesday announcement, Alliance & Leicester is down 10 per cent and HBOS 10 per cent, in anticipation.

It seems a long time ago, but the market opened the week on Monday with a 3.5 per cent, led by the miners as several commodities hit new price highs.

Legendary investor Warren Buffet’s offer to help bail out the ailing municipal bond market also breathed life into financials. This soon evaporated, however, as the offer on the table ultimately proved unattractive, only taking the best assets of the monoline insurers, and several rejected it out of hand.

Roll on poor numbers from UBS and then B&B and the market has ended up back where it started the week.

Stokes believes much of the volatility in the mining sector this week, which has seen alternating rises and falls for the majority, has been caused by a combination of profit takers and other investors buying into the dips.

Elsewhere, housebuilders took another beating on the likelihood of fewer rate cuts with Persimmon and Bovis giving up 3-4 per cent each.

Diageo was on of the bright spots of the week, the drinks company reporting sales up 4.5 per cent, buoyed by US demand and sales of premium spirits.

Perhaps the Wall Street traders are steadying their nerves.

Looking forward, King says the recent market falls have led to a rare convergence in the equity/gilt ratio.

He says with 10 year gilts yielding 4.5 per cent, equivalent to 3.5 per cent for basic rate taxpayers, and the FTSE Allshare yielding 3.5 per cent, now could be the time to buy.

“The market ought to have found a strong support level,” he says. “Dividends are pretty well covered and the one year outlook shows it pays more to hold equities than gilts and that is rare.”

He also points to recent net outflows from investment funds as a classic contrarian indicator. Perhaps the outlook is not as bad as King fears and it certainly should be a lot clearer after the bank’s reporting season is done.

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