In the current investment climate, long-only managers’ hands are effectively tied. New Star’s Guy de Blonay predicts that when a market turnaround comes, however, financial firms will benefit most ...
The current year has brought with it challenging trading conditions. While there was weakness in the financial sector in 2007, investors were able to identify the potential problems they faced. An analysis of the situation suggested that they avoid stocks with US sub-prime related exposure, such as investment banks, and retail banks with short-term funding issues, such as Northern Rock. While US and western European bank shares trended south, financial companies in other regions made gains, notably Turkish and Brazilian banks and Chinese real estate companies.
Where there appeared to be some rationality behind share price movements in 2007, indiscriminate market movements seemed to prevail in the first quarter of 2008. Economic pressures were varied and continue to spread well beyond the banking sector. The high prices of oil and other commodities fuelled inflation concerns and fed through to weaker profit margins in industry. Global economic growth is expected to slow and US sub-prime related problems were forecast to continue through the first half of this year. Distrust between banks remained at the quarter end amid fears that there would be further corporate failures. Bear Stearns was the first to go in 2008 and there are likely to be other casualties. A number of hedge funds and leveraged vehicles assumed a ‘zombie-like’ state – continuing to operate but effectively dead.
In such conditions, the hands of the long-only fund manager are temporarily bound. The stockmarket’s risk-pricing mechanism was knocked out of kilter in early 2008 and the levels of volatility made it easy to get burnt by attempting to play aggressively or trying to be too clever. Stock analysis and the amount of due diligence required has multiplied, with the credibility of analysts’ research and company reporting called into question. The resulting lack of trust hinders a fund manager’s ability to build and aggressively pursue convictions. In this environment, a focus on preserving capital is prudent.
The US and European markets present different challenges. In the US, much of the pain seemed to be out in the open at the end of the quarter. Fire sales, write-downs and management changes featured heavily and some of the problems were booked into 2007 numbers. The Federal Reserve, while criticised for being behind the curve, was proactive. By providing liquidity to investment banks, altering regulations and policy and overseeing the rescue of Bear Stearns, the Fed ensured the functionality of capital markets. This should pay off as it feeds through in the coming months. The question may now shift to confidence restoration. Hedge funds shoulder some of the blame alongside the banks, for the systemic risk, and addressing this will help achieve the normalisation of markets.
European banks were slower to put their affairs in order and suffered particularly severe selling. Within the sector, corporate boards proved reluctant to be the first openly to state their exposure to risk for fear of share price falls. This hesitancy left trust between banks fragile if not non-existent. In turn, the lack of inter-bank lending and the credit drought made economic expansion in the wider economy more difficult. Leadership from central banks was also weaker than in the US, with the Bank of England and the European Central Bank relatively frozen in their tracks. In March, however, there were hints from the ECB that it was becoming more prepared to move in sync with the Fed.
While pressures remained at the quarter end, investors had a greater understanding of the problems they faced and further clues about the likely severity of the US slowdown. With relatively weak economic prospects priced into share valuations, it is possible that surprises will come on the upside rather than the downside.
If the slowdown is mild, as early indications suggest, stockmarkets should bounce back quickly when confidence returns, potentially recovering most if not all the losses suffered in the first quarter. Once the recovery comes, it is likely to be significant and fast. In late March, institutional investors were sitting on large amounts of cash, which they will be looking to invest. The stocks that lead the climb are likely to be those that have been marked down the furthest – namely financial services companies.
• Guy de Blonay is a specialist global financials manager at New Star Investment Funds
© 2008 funds europe