Slowdown bodes well for financials

The Northern Rock fiasco damaged the Bank of England’s reputation but, despite a slowdown in the housing market and predictions of more rate cuts, financials will offer good value.

The Bank of England is damned if it does and damned if it does not. Earlier this year when inflation temporarily breached the 3% mark, it was accused of not applying the brakes hard enough; yet conversely, as soon as the housing market begins to slow there is a hue and cry about impending recession.

Unfortunately, monetary policy is like a badly plumbed shower. When it is steaming hot, the cold is turned on and yet the temperature appears not to change; so a little more cold is added, whereupon scalding water is transformed abruptly to freezing.

In a similar fashion, changes in monetary policy direction invariably lead to similar overshoots in the highs and lows of economic growth. The Bank, therefore, deserves some credit for having engineered an unbroken run of consecutive quarterly growth since it took control of monetary policy back in 1997.

The question is: can the Bank keep it up and what are the implications for equities? In its latest quarterly Inflation Report, the Bank hints at potential rate cuts given expectations of slower economic growth in 2008.

Why this sudden dovishness? It all relates to the credit crunch. While the Bank was correct to turn on the cold tap, the credit crunch has interrupted the water pressure so more temperature fine-tuning may be needed.

The decline in equities, the slowing data from the housing market as well as weakening business surveys point to rate cuts in the course of the coming months, and I anticipate the base rate moving towards 5% by mid 2008.

So is this the right time to enter interest rate-sensitive stocks? The banking sector has taken a serious bashing. Investor sentiment is arguably near an all-time low, a situation not helped by the first run on a British bank in more than a century.

To give an idea of the severity of this feeling, some market commentators are beginning to make comparisons with the early 1990s, when banks suffered a collapse in profits as Britain entered recession.

Some have argued that price/earnings (P/E) ratios were lower in 1990 than they are today, which suggests banks may have further to fall. This may be true, but cash returns and gilt yields were higher in 1990 so relative P/Es across the market were lower – or earnings yields higher – to compete. From a dividend yield perspective, the banking sector is the cheapest it has been in more than 20 years.

As the graph above shows, banks have been underperforming the wider market for some time, and may well be due a rerating. In the past year alone, they have underperformed by more than 23%. This degree of deficit has only occurred three times in the past 35 years, and is usually followed by a bounceback: on average outperforming the wider market by 9% over the following 12 months.

A lower bank rate would have the advantage of steepening the yield curve. The reason for this is that short-dated bonds yield less than longer-dated bonds. Banks tend to prefer this arrangement as it means that they can borrow cheaply to lend or invest longer at better rates.

A lower base rate also has the advantage of allowing banks to make money from margin drag as they reduce rates on savings but delay passing on the savings to borrowers. What is more, the effective removal of some of the more aggressive lenders also paves the way for established lenders to regain market share.

British banks report half-yearly rather than quarterly and this also exacerbates and stretches out the pain. In turn, uncertainty fuels rumours. Analysts are unclear what to think, and capitulation is traditionally a good contrarian ‘buy’ signal.

The most compelling reason to think banks are oversold, though, is plain old common sense. There is a disconnect in the market: miners are suggesting the global economy can keep ticking along happily while financials are predicting Armageddon. Surely something has to give. Either we are about to enter a recession and profits are due a big structural collapse or banks deserve to recover.

What is clear, however, is that the housing market in Britain is slowing. Many investors may not realise that in times of negative or slowing house price inflation financials have a greater-than-average chance of outperforming.

According to research by Morgan Stanley, in the past five housing market slowdowns that have occurred since 1988, the life insurance sector is the only market to have shown rises in all of these periods.

Banks generally outperformed and were ranked eighth out of 30 sectors with general financials following closely behind, in 11th place. There is some logic to this. The stockmarket tends to be forward looking, so a slowing housing market is usually accompanied by interest rate cuts, which lay the foundations for improving conditions for financial stocks.

The danger is that the doom-and-gloom philosophy becomes self-fulfilling. A closer look at economic data and company commentary, however, shows the economy is in a reasonable state.

Purchasing manager indices are still above the 50 watermark that separates economic expansion from contraction, and the labour market continues to expand: 178,000 more people are in work than a year ago, and job vacancies are still rising.

So we are some way off recession territory, and with defensive stocks such as food and drug retailers looking expensive. Better value lies in financials and some of the more cyclical areas of the market. The Bank may have had its reputation tarnished by the Northern Rock fiasco, but it would be wrong to bet against its earlier track record.