The UK equity market at the end of July was ugly but the experts concur – the FTSE had it coming.
Big names from the big investment houses foresaw a correction long before it struck, with warnings from Fidelity, Gartmore, Morgan Stanley as well as those from Resolution and F&C. But following a 7 per cent fall, where do we stand?
Did the correction come and go in a week or is the market just getting started?
The doomsayers had plenty of reason to doubt equities. Rising interest rates, high inflation, increases in oil prices, pressure on wages and rising sterling all spelt trouble for company profits.
But the catalyst was much less a function of companies than one of markets; the increasingly lax lending that was fuelling a mergers and acquisitions spending spree.
In the US, problems in the sub prime mortgage market had been creating a backdrop of nervousness over credit since February.
F&C Investment Trust manager Jeremy Tigue says: “A lot of mortgages are on teaser rates, which are fixed for two or three years and then revert back to the standard rate. In those two or three years rates have gone up a lot. People can’t afford the higher repayments, so they default.”
These defaults are starting to add up. Recently, the largest mortgage lender in the US, Countrywide, announced a profit warning, leading to fears that the problems were spreading to the prime mortgage market and beyond.
Gartmore senior strategist Chris Iggo explains: “A lot of corporate bond-like securities were linked to the market. They had disruption to their cashflows so were worth less. People tried to get rid of them and the sell-off widened to corporate borrowing across the board. Investors are not willing to buy corporate bonds at the moment so liquidity is drying up.”
It meant private equity financing for the Alliance Boots and Chrysler deals hit a brick wall.
Tigue says: “They were trying to parcel out debt to investors and they hit an investor strike. So the banks were left with all this debt on their balance sheets that they weren’t expecting, restricting their capacity to lend for more M&A.”
During the past year the prospect of takeovers has been one of the drivers of the stockmarket, so taking away this prop seriously unbalanced the markets.
The heady rush of mergers and acquisitions stopped pulsing in the ears of investors, and the great sell-off began as F&C stewardship fund manager Ted Scott had predicted. But Scott had raised the possibility of falls of 15 to 20 per cent. So is this the first of many gruesome weeks for the FTSE?
The weight of opinion is that a good proportion of the correction is over. Many are taking heart from the fact that there are still some mergers and acquisitions in the pipeline.
Williams De Broë head of research Jim Wood-Smith says: “There is no reason to suppose that the appetite and funding for sensible-sized deals will slow up – take Emap and Resolution, which continued in the midst of the market falls.”
They argue that the companies themselves remain robust, profits are meeting expectations and the economic backdrop is benign.
New Star Asset Management joint chief investment officer Stephen Whittaker says: “I have been saying for a couple of years that the markets will be punctuated by bouts of volatility but until I see a significant deterioration in the global economy, I think that this bull market has legs.”
Wood-Smith says: “I expect continued market volatility with corrections here and there but I am not convinced that there is a need for panic and a downward spiral.”
The correction, others argue, may also have removed the heat from the market, and reduced the threat from rising interest rates.
Rathbone Unit Trust Management chief investment officer Julian Chillingworth says: “Generally speaking, corporate profitability has been strong, which has led to concerns of economic growth fuelling inflation.”
He says If borrowing becomes more expensive, profits may be slightly dampened, and there may be less need to raise rates.
Gartmore UK equity income cautious managed fund manager Chris Burvill says: “The pressure for rates to rise might be easing a bit and we might be able to see the end of the rate cycle coming sooner.”
Many are already seeing this correction as a buying opportunity. Whittaker says: “I am using these dips to buy attractive companies at better prices.”
Others would prefer to hang back in the very short term.
Tigue says: “I think things will come out in the wash in the next couple of weeks. The next fortnight or so will be turbulent, then it’s a good buying opportunity.”
Royal London Asset Management special situations fund manager Derek Mitchell says many managers will wait for September.
He says: “There are too many uncertainties in fund managers’ eyes to commit great swathes of new money. They may hold it as cash until things settle down in September.”
Others expect more limited corrections in the coming weeks and are looking to buy in at the floor.”
Iggo says: “Personally, I would wait a little longer. There will be more bad news to come out of the credit market. If it goes down to 6,000, the p/e ratio will be 12, which is attractive by any historical compar-ison. If you get 6,000 or below, it might be time to start nibbling away at some bargains.”
But there are some who do not think the buying opportunity is just around the corner.
Burvill says: “Other fund managers say the economics are sound, the valuations are sound and the balance sheets are sound but the banking sector is 30 per cent of our profit and that’s a concern right now. Others will say HSBC had good results and all that is true but there is something in the lending system we need to be vary of.”
Added to this, there is always the possibility that negative sentiment alone will drag the markets south.
Wood-Smith says: “Markets are irrational beasts, and this may be one of those moments where the herd take flight without need.”
But the presence of a few bears, Whittaker argues, could be just the sign we need that any further corrections will not be too painful.
He says: “It would be more concerning if everyone was optimistic, as that is a sure sign of a bear market. Healthy markets take into consideration genuine concerns.”
So while the gloomy alarmists are few and far between, the occasional bear is actually a sign of a healthy market.
It is only if the odd warning becomes a general outcry that we have to start worrying again.