Credit crunch pessimism hits home

Consumers are curbing their spending as the credit crunch spreads to the broader economy – and high street retailers in particular brace themselves for a weak Christmas.

The British stockmarket has been lurching towards the end of the year with the most appalling hangover from the credit crunch and, as we head into Christmas, there is no sign of an imminent recovery. While central banks may have the tonic needed to pep up the domestic consumer early next year, there may be yet more agony waiting for exporting companies. The question is whether British companies can pull through, or whether fund managers need to simply crawl back to bed to wait for the pain to pass.

At the moment the source of pain is the financial sector. There has already been plenty of bad news emerging from the murky depths of the financial world, but Chris Iggo, a senior strategist at Axa Investment Managers, expects the big global banks to have more in store. Gregor Logan, joint chief investment officer for New Star, shares this view. “As we saw from the limited positive reaction to the Barclays announcement [that its exposure was not as bad as had been rumoured] the market simply did not believe it,” he says.

Problems in the financial sector are nothing new, but until now there were plenty of experts predicting they would stay contained within the sector. Unfortunately, it is becoming increasingly obvious that they will not – they are filtering through to the broader economy. Part of this dispersal of misery will come through restrictions on lending to companies, causing a slowdown in other stocks. Martin Cholwill, a UK equity fund manager at Royal London Asset Management, explains: “In a modern economy you need strong banks for the overall economy to be strong. The banks will charge smaller companies more to borrow. Going forward there will be a repricing of credit risk and we are expecting a broader downturn.” Scott Meech, UK equity fund manager at Threadneedle, agrees: “A month ago people were arguing as to whether the credit crunch could have an effect on the real economy. It is clear that it is doing so.”

The other way the pain is being passed on is to consumers, who do not need anything else to worry about. Their disposable incomes are already under pressure from relentless price rises. A steady stream of interest rate hikes since the summer of 2006 has pushed mortgages sky high.

Add in the increasing costs of energy, which is inflating utility bills and pushing the price of petrol at the pump to £1 a litre, and many consumers are struggling to make ends meet. Then add in a tightening of lending, as banks slash overdrafts and credit card limits to get control of their capital, and consumers lose their safety net. They, therefore, are expected to rein in their spending dramatically in the immediate future.

The misery is thus passed on to any area exposed to consumers, such as retail, housebuilders and leisure companies. The high street in particular is expected to have an exceptionally poor period, epitomised by a bleak Christmas.

Fortunately, this could be what the markets need, because if things get bad enough, the central banks will have to step in. Logan explains: “The worse Christmas is, the more likely we are to get a rate cut. Once the market starts to discount the cut in interest rates, it will be set for a turn. We are close to lows in the financial sector now. It is impossible to say whether that will be today, next week or next month, but it is close.”

But the concerns for the British market are not necessarily over with a consumer and financial sector recovery, because as interest rates seem to hold out hope for domestically focused companies, there are new dangers awaiting those exposed to international markets.

During the difficulties of the last couple of quarters, these companies have held the market together. Iggo explains: “Mining and oil and industrials are doing well because they are much more exposed to the global economic cycle. The domestic consumer is weaker, but a lot of companies are exporting to booming emerging markets.”

Cholwill adds: “We had a bid for Rio Tinto, highlighting the strategic value in commodity prices.” This sector is vital to the British market and constitutes a far larger proportion than consumer stocks.

There is no reason to see the sector stutter, as long as emerging economies continue to grow and display an insatiable appetite for resources.

But the experts disagree whether growth in emerging economies is certain to stay on track. Iggo has confidence in them. He says: “Growth within the US has slowed dramatically. In the past, if there was a slowdown in the US you would expect the rest of the world to follow, but it’s not the case now. Outside the US, economic growth is holding up quite well. Emerging markets are booming and are becoming increasingly important.”

One camp of experts points to internal markets within emerging economies, as demand for consumer goods from China and India grows, and emerging economies invest in their own infrastructure. But others are less convinced. “The West is priced for bust and the East is priced for boom, but the hope that the Eastern economy will decouple from the West is simply a hope,” says Logan. “To price for a boom in the rest of the world, which is less than 50% of the world economy, is unrealistic. It makes the Chinese stockmarket quite vulnerable. Typically any market that is parabolic in shape will collapse, and it is.”

A collapse in emerging markets would be a serious blow for the resources sector and for any company exposed to the region. It would also hit funds hard where they have taken a strong position in emerging markets in recent months.

Fortunately, there are always ways to make money, and should the worst come to the worst, there will still be some stocks that are not feeling the pain. Meech says: “We would expect to see upwards re-rating of staple consumer stocks, telcos, aerospace, food retailers and specialist medical. Those areas have strong growth, they’re not cyclical, and they are not exposed to the economic background.”