Weekly outlook

Early-cycle winners from interest rate cuts
 
By Tom Stevenson, 29 October 2008

The publication this week of the Bank of England’s twice-yearly Financial Stability Review (FSR) shows how the world has changed in six months. It is a downbeat assessment of the financial crisis and economic prospects and it makes no attempt to gloss over the ongoing difficulties or to pretend that we are past the worst. The FSR highlights a number of continuing vulnerabilities in the UK and elsewhere. These include: A sizeable funding gap at UK banks, which have lent out around £700bn more than they have taken in customer deposits. Much of this has come from overseas banks, which are now looking to retrench.

"Most economists expect the Bank of England to cut the UK’s base rate by at least half a percentage point next week." Tom Stevenson

• A likely increase in negative equity. The Bank says that a further 15% fall in house prices could push about 1.2 million households into negative equity. The curse of the early 1990s looks like re-appearing.
• New and larger estimates of losses on financial instruments. The FSR now believes that US, European and UK losses have more than doubled to $2.8trn compared with $1.3trn at the time of its April report.
• Despite the injection of capital into many banks, the wider financial system remains at risk, with the FSR highlighting hedge funds, insurance companies and emerging markets in particular.

All of this makes sense. After a debt-fuelled expansion of 20 years or so, it would be unreasonable to expect the unwinding of the excess to happen overnight. The extreme market volatility in recent weeks is a reflection of the growing acceptance by investors that the unravelling will lead to a prolonged recession, with falling asset prices and corporate earnings and rising unemployment.

None of this will be lost on central banks and the next few weeks are likely to see the kinds of falls in interest rates that would have been inconceivable only a few weeks ago. Most economists expect the Bank of England to cut the UK’s base rate by at least half a percentage point next week, with some pencilling in a possible 100 basis point reduction.

The Bank’s freedom to act has increased this week with a sharp drop in inflation expectations. A survey conducted by YouGov and Citigroup shows that inflation expectations fell sharply this month, both for the year ahead and longer-term.

The average reading for inflation over the next year was 2.9% in October compared with 4.4% in August and September and a peak of 4.6% in June. Longer-term expectations were 2.9% in October, down from a peak of 3.9% in May.

This is good news for the Bank of England’s monetary policy committee, which for much of this year has been grappling with the apparent contradiction of a slowing economy but rising prices and inflation expectations. Recession may not be good news but with all the data pointing in the same direction at least the Bank can move decisively to ease the pain.

Some economists now expect UK base rates to be as low as 3.5% by the end of the year compared with today’s 4.5% and to have fallen to 2% during 2009. As noted here last week, we have made a clean break with stagflation and moved into a new reflation phase.

Last week we said that this could be good news for bonds, which rise in value as interest rates fall. But what about equities?

Nomura has looked at the likely beneficiaries of lower interest rates and calculates that so-called early-cycle sectors such as retail, media and real estate have historically done well when short-term rates have fallen. They contrast with sectors such as capital goods and steel, which have underperformed during the reflation phase of the cycle.

Banks are another area which has done well in an environment of falling rates but, as the Bank of England’s stability report confirms, there remain considerable balance sheet risks here.

Nomura thinks that early cycle stocks have another distinct advantage in the current environment: more of their earnings risk has already been factored in by analysts. Although the full extent of declining earnings is probably yet to be felt across the board, banks and retailers at least have started to receive meaningful downgrades.

They are also much cheaper on average: real estate stocks trade on a lower price to book value than during the early 1990s recession; retailers are more lowly-priced compared with sales than at any time in the past 20 years; and media stocks are throwing off more cash as a percentage of their share prices than they have during the same period.

During the market turmoil of the past few weeks, fundamental analysis has largely been thrown out of the window. Forced liquidations and deleveraging have driven everything lower regardless of economic or individual sector or corporate considerations. That will surely change as the dust settles and the benefits of rigorous research reassert themselves. The old-fashioned art of picking winners and losers will come back into vogue.