Shattered nerves on borrowed time

The high cost of borrowing hits financial institutions and households causing growth to slow. But a stable housing market and lower rates will restore investors’ confidence in equity markets.

The prices of commodities – and most importantly oil – have fallen significantly. However, most equity markets – not least the FTSE 100 – have failed to benefit from this development as the economic outlook for many developed economies worsens and bad news continues to emanate from various corners of the financial sector. Instead, government bonds have rallied, as analysts reduce their forecasts for growth and interest rates.

Given the high levels of volatility in the financial markets, difficult credit market conditions and concerns about inflation and economic growth, investors are justifiably nervous. With all this uncertainty, capital preservation will be at the top of many investors’ lists of criteria, particularly for those who have witnessed significant losses in their stockmarket holdings this year. This is highlighted by the Merrill Lynch Fund Manager Survey for July 2008, which shows that investors continue to remain extremely cautious, with well above average holdings of cash and low equity positions.

So what conditions are needed to restore confidence in equities and encourage investment in the stockmarket? To find the solution, it is necessary to identify the problems. One of the biggest and most widely-publicised concerns affecting corporates, financial institutions and households is the high cost of borrowing.

The three-month London Interbank Offered Rate (Libor), which is widely used to price mortgages, loans and derivatives, is much higher than official policy rates. While historically it has been roughly 15 basis points or so higher than overnight policy rates, in the past year three-month Libor has been as much as 115 basis points higher.

Even now, one year on from the start of the credit crunch, three-month Libor is about 75 basis points more expensive than overnight policy rates. Add to this the increased difficulties in obtaining a loan or mortgage in this environment, as lenders have tightened their credit standards, and borrowing has become a difficult, not to mention expensive, task.

Borrowing rates are so high because banks themselves are looking for capital to shore up their balance sheets, with many having revealed large losses, but they fear counterparty risk. With the fate of Northern Rock, which was eventually nationalised by the British government, fresh in their memories, banks are reluctant to lend to each other.

To ease this situation, we need to see trust restored between banks, which should begin to improve when the stream of bad newsflow dries up and the housing market stabilises.

In addition, British official interest rates also need to fall. To help ease the funding pressures in the economy and the weak growth outlook, the Bank of England needs to cut interest rates further from the current 5.0% level.

High levels of inflation are also eroding profit margins and consumer confidence, driven in no small part by the sharp rise in the price of oil over the past year. In Britain, consumer price index inflation is running at 4.4%, well above the Bank of England’s 2% target, while the retail price index, the measure oftenused in wage negotiations, is 5.0%. Concern about inflation is not just limited to Britain, but is globally widespread across both developed and emerging economies, largely thanks to the high price of commodities – particularly oil and food.

However, inflation usually recedes in low growth environments because of declining demand. Growth is now weak and/or slowing in America, Britain and the eurozone, with second quarter British real GDP growth revised down to zero, quarter-on-quarter.

Furthermore, countries such as India, Indonesia, Malaysia and Taiwan are reducing their oil subsidies, which should also reduce demand. And if commodity prices continue to fall, a reduction in inflation expectations against a background of excess capacity could sow the seeds for significant monetary easing and a sustainable British stockmarket recovery in 2009.

Tight credit conditions, high commodity costs, a cyclical downturn in consumption, falling house prices, rising inflation and bad newsflow all continue to pose significant risks to growth and earnings outlooks for the second half of 2008 and for 2009, while high levels of volatility only serve to shred investors’ nerves further. Volatility in financial markets is off-putting for many investors, unless they are patient and prepared to invest for the long term.

However, British equities are at historically cheap levels on a price/earnings basis and when these factors improve, underweight investor positions and ongoing merger and acquisition activity may provide extra support once market sentiment finally improves.