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Central banks will call the shots this year

Friday 18 January 2008 05:43PM

As we enter 2008,  there are big questions out there:
·   How and when will the credit crunch come to an end?
·   Will the UK economy suffer a significant slowdown or recession?
·   Will ongoing inflationary pressures from oil, commodity and food prices limit the ability of the Bank of England and other central banks to lower interest rates?
 
The sub-prime crisis has affected credit markets in general and created the potential for contagion into the general economy. It is now clear that banks are tightening the amount and terms of their lending, not only to households, but also to commercial and industrial borrowers. This leaves the Bank of England and other central banks with a dilemma.

The need to provide the banking system with liquidity to avoid a debt crunch, but at the same time being wary of stimulating inflationary pressures when headline inflation is uncomfortably high due to higher oil, commodity and food prices. So far, the Bank of England has delivered a small interest rate cut and provided significant liquidity to the banking system alongside other central banks.
 
In our opinion, the outlook for world markets is totally dependent on the actions of central banks and whether they correctly judge the appropriate monetary response to the current situation.
 
At present, in developed nations, there are virtually no inflationary pressures from internal sources. In the UK, the labour market is benign, unemployment is forecast to rise in the next 12 months, house prices are falling and public spending is under pressure. All these factors will provide deflationary forces for the UK economy from here. The only inflationary influences on the economy are from external factors, i.e. rising food, energy and commodity prices. The same is true in the US and Europe.

Demand for food, energy and commodities is coming from the dramatic growth in emerging markets. Quite frankly, it doesn’t matter whether UK interest rates are 5.75% or 3.75%: they will have no effect on the drivers of inflation. Indeed, it could be argued that higher prices from energy, food etc are more likely to affect wage demands if interest rates remain high and the “man in the street” has to suffer higher mortgage payments as well as higher energy and food bills.
 
The Bank of England is trying to unlock the credit market jam by working on the mechanism through which money can be pumped into the banking system. The Bank of England is dissociating the problems in the financial sector from the problems in the real economy. However, by not cutting interest rates aggressively enough, they are allowing money markets to dictate interest rate policy and hence inter-bank rates remain too high.
 
It is our opinion that the Bank of England should and will cut interest rates significantly over the next few months to offset the deflationary domestic influences on the economy.
 
In the US, if the Fed does not cut interest rates aggressively it will condemn the US economy to lower growth than is warranted by its internal dynamics in order to keep global inflation within bounds, whilst emerging markets continue to grow at a rapid pace. This would be the equivalent to Germany accepting lower growth after the single currency introduction in Europe in order to achieve overall acceptable inflation within the Eurozone, whilst Ireland and other peripheral nations grow rapidly.
 
We believe that the Americans will not find this acceptable and we forecast significant interest rate cuts in the US during 2008. This should allow the US economy to avoid recession and allow growth to pick up in the second half of 2008 and onwards. It will also increase inflationary pressures globally and cause some emerging nations, such as China, to raise interest rates and consider further appreciation of their currencies against the US dollar.
 
In conclusion, we believe that the current economic situation warrants significant interest rate cuts in the UK and elsewhere. We are long past worrying about “moral hazard”. Central banks will become increasingly aware of the necessity to cut interest rates in the next couple of months and they will move aggressively to do so. If they do not, then the outlook for markets will be bleak.
 
Positioning for this global outlook
 
Our strategy is based on the presumption that the Bank of England will cut interest rates aggressively over the next few months. The worst performing sectors during the last 12 months have been the financials and domestic consumer-orientated sectors. 
 
Mega-Caps
The outperformance of large-cap companies should continue, although excellent medium-term investment opportunities are now beginning to appear in selected mid-cap stocks. The current portfolio has 79% in the FTSE 100 and 21% in the FTSE mid-cap.

Banks and Financials
Our performance has been held back by the financials, however the relative overweight position in each stock remains small with no stock representing more than +2% against its relative index weighting. We do continue to be committed to this area of the market. Our significant positions are in Banks (18% of portfolio) and Life Assurance (7%). The financials generally should benefit from a falling interest rate environment.
 
Emerging Market Consumption
Companies with exposure to emerging markets have performed exceptionally well during 2007 and although many of these companies have secular attractions, their ratings now appear somewhat stretched in the short-term against other areas of the market. We are starting to reduce our exposure to defensive consumer staple companies with emerging market exposure such as Diageo, British American Tobacco and Unilever, while maintaining our positions in more economically-sensitive emerging market exposed companies such as GKN, Rolls Royce and Charter which have performed less well.
 
UK Domestic Cyclicals
We have remained very underweight in the domestic consumer sectors until very recently. We now believe that UK domestically exposed sectors are discounting a much larger downturn than is likely in a falling interest rate environment. These sectors are now trading on multiples similar to the early 1990’s recession. We are therefore going overweight in many of these areas of the market. However our stock risk is limited by buying a number of companies in each sector. Our recent purchases include Daily Mail and General Trust, Greene King, Enterprise Inns, Bovis Homes, Marks and Spencer, Next, Savills and Whitbread. Over the last few weeks, approximately 10% of the portfolio has been moved into these areas of the market. 
 
Stronger for Longer
Given our global macro-economic view, we have maintained our position in companies which should continue to benefit from continued strong growth in the global economy. Within the industrial areas of the market we continue to own Invensys, Charter, Morgan Crucible and Bodycote, while we retain our holdings in recruitment companies such as Michael Page and Hayes.
 
To conclude, 2008 is likely to be as exciting and interesting as 2007. Assuming policy makers act appropriately, recession should be avoided.  Financials and domestic cyclicals should recover and defensive areas of the market will not be as strong. Emerging economies will need to slow their headlong growth and medium-term risks lie with higher inflation, not with recession. 
 

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