Julian Chillingworth takes a look at recent developments in the continuing credit crisis and the potential effect on the economic state of 'UK Plc'
R.I.P. Lehman. The death of one of Wall Street's biggest names has shocked the system, sending bank shares plummeting and credit markets into a spin.
The collapse of Lehman has almost rendered inconsequential the US government's billion-dollar rescue of mortgage giants Freddie Mac and Fannie Mae. Lehman, having survived the panic of 1907, the Great Depression in the 1930s, the collapse of Long-Term Capital Management, and the implosion of the tech boom, could not survive the pressure of the credit crisis. The bank's collapse had been anticipated for some time by investors, but markets were unprepared for the reaction of the US authorities who stood back and allowed a run. Prospective 'white knights', Bank of America and Barclays, also retreated as the government failed to offer any surety, and Lehman was allowed to crumble in favour of the tax-payer. Add to this the takeover of investment bank Merrill Lynch, and insurers AIG putting out the feelers for further funding - a potentially huge time bomb - and the market is bracing itself for the next phase of the crisis. It's high drama; it's globalisation; it's the biggest re-shaping of the banking system ever. Big institutions have been told - you're not too big to fail.
Room for optimism?
The credit-line thrown to Freddie and Fannie was never going to be a quick fix, but shoots of hope were emerging that the mess was being contained. These shoots have now all but been obliterated, and this has implications for everyone. Lehman, renowned for its fixed income trading, held billions of dollars of gross assets that were exposed to the commercial and residential property markets in the US. Lehman has lent billions to other institutions - banks, pension funds, hedge funds - and it is the unwinding of these positions that is going to intensify the credit crunch. The Federal Reserve has broadened the collateral it accepts for loans, and ten US banks have created a $70 billion fund, but further casualties still look inevitable. The actions of the US authorities are right, a form of tough love should result in a healthier environment in the longer term.
However, in the short term, the outlook looks very messy indeed. There is no escaping this; no flowering-up the language or softening the blow. The US tax-payer might have been spared another bill (for Lehman), but one should not forget the huge amount of money involved in shoring up other institutions. This burden could yet expose fundamental weaknesses in the US economy, with much depending on the direction of the housing market and employment trends from here on in. Viewed like this, the upward revision of second quarter GDP figures looks increasingly like a rogue element.
What does this all mean for the UK economy? Apart from City job losses, if you believe that the UK lags behind the US, then we are in for a rocky ride. Banks are already difficult to value in this environment, and this collapse has deepened that dilemma. The City cowered under the shadow of the Lehman meltdown - the FTSE was down around 4% - but the blow to confidence in the banks and in lending is much harder to quantify. The next step for the authorities will be to assess the level of exposure to Lehman held by other banks - the likes of RBS, HBOS and Barclays Capital all have substantial exposure to the US mortgage market. This can only lead to more write-downs, although the size of these remains an unknown.
Further falls in house prices could aggravate the economic downturn, but could also steer the Bank of England's hand on cutting interest rates further as inflation pressures subside. As for the consumer, spending is likely to remain subdued well into 2009 and 2010 as the excesses of yesteryear unwind. Inflation concerns might start to fade as energy and food prices fall, but only time will tell whether these will be enough to coax out the wallets.
We always felt that the recent relief rallies were premature, and that investors would soon revert to agonising about slower global growth and the credit markets. However, like many others, we did not expect them to have to do so in such spectacular fashion. UK investors must still grapple with historically higher interest rates, economic deterioration and an ineffectual government to boot. For those investors brave enough to buy into the market, perhaps this is the optimum time to invest in deep value.
However, beware - with so much uncertainty around, the risk of capital erosion also remains high. Further rationalisations in the banking sector and beyond are likely; spreads continue to widen. We believe the key to negotiating the current market is to side-step companies with high levels of financial and operational gearing. There is a high possibility these companies will be the first to go under. It is all about quality at a value price. These are companies that demonstrate balance sheet strength; cash generation; visibility of earnings. The weaker outlook for Sterling must also play a part in this equation. Investors would do well to take a glance at UK-listed companies with significant overseas earnings. In the short-term then, we expect the flight to quality to continue, and certain cyclicals and highly leveraged financials remain a no go area.
Those who hold their nerve during these difficult times should be rewarded, but do remember that the maximum upside, on an historical basis, has come when investors capitulate completely and the economic environment is at its bleakest. That scenario is most probable in 2009 for UK investors.
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