It's Official

Last week government figures confirmed that the UK is indeed officially now in a recession for the first time since 1991. The economy shrank by 1.5% in the last quarter, the second consecutive quarter of decline which is generally accepted by all as a recession. This confirmation seems to rather contradict the spot of political gardening Baroness Vadera was doing the previous week. The green fingered Baroness, in a television interview on ITV, spoke about seeing the ‘green shoots’ in the economy. Her cautious optimism was clearly rather embarrassing for the Government as the economic data continues to deteriorate. It seems gardening has long been a popular pastime for Ministers, I remember Norman Lamont making similar comments as Chancellor during the last recession.

Of course, official confirmation that we are in a recession is hardly a shock. The evidence is all around us with businesses closing and unemployment rising every day. This crisis started in the financial sector and has swept out across the broader economy. Just take a look at the High Street, the downturn has hit the shops like a flu epidemic. As we know, flu takes its toll on the old, young and the weak. We have seen Darwinism in progress as famous names have disappeared from our High Street. First Woolworths and more recently Zavvi have fallen into administration. And others elsewhere are suffering too. In the car industry prices have fallen sharply on both new and used cars, indeed one car dealer is offering a “buy one get one free” deal!

The real shock in all this is the magnitude and speed of the downturn. Even Mervyn King, the Governor of the Bank of England, in his speech in Nottingham last week referred to the economy having "fallen off a cliff." He sited the failure of the investment bank, Lehman Brothers, four months ago, as the point in time that marked the beginning of the collapse of confidence in the world’s banking system. This then led to an unprecedented and synchronised downturn in business and consumer confidence around the world.

But there has and continues to be a really concerted effort to prevent this recession from deepening into a depression similar to the one that Japan experienced in the 1990’s ‘the Lost Decade’ as it is referred to. Interest rates in the UK have been slashed to 1.5% and there has been a series of bank bailouts to cut the cost of lending and allow both businesses and households access to credit once more. Is this working? Well it is far from an easy task - banks are being asked to repair their balance sheets so this means they must hoard the cash. At the same they are being told to lend to their customers but to the frustration of the Government they are not doing so enough. And this is the same Government that has taken stakes in many major banks using taxpayers’ money.

One suggestion being made is to clear the decks and take public ownership of the banks, to nationalise them. It is certainly true that the Government can afford to take a long term view and by doing this could remove the bad assets and provide capital to the markets. However, this is politics getting in the way. To nationalise the Banks in the UK could undermine the fabrication of Capitalism and could bring an end to New Labour with a shift towards Socialism. It is important in a free market economy that there are allocators of capital beyond the Government and the banks play a key role in this. Furthermore, it is likely that if this Government takes ownership of the banks now, then a future Conservative government would of course privatise them for profit and to extend their period of government.

I believe we have several more steps to take before nationalisation and, from his speech, Mervyn King, seems to agree. The conventional instrument maybe interest rates, however, he spoke about considering ‘a range of unconventional measures.’ There is quantitative easing. Mr King described how the Bank of England would look to purchase a range of financial assets from the banks in order to expand their reserves and allow lending to function once more in both the corporate and household sectors. Some critics have argued that as a nation we have spent our way into trouble, so surely it is hardly a good idea that we try and spend our way out of it.

That said some of the other measures that have been taken by the Government have been aimed at encouraging consumers to go out and do exactly that - spend more. But will this work? The temporary reduction in VAT from 17.5% to 15% was dwarfed, to a large degree, by the large discounting by most UK Retailers and confidence amongst consumers remains low even though the cost of living has fallen with reduced mortgage payments, petrol prices and energy bills. House prices have fallen and people will gauge their net worth relevant to this benchmark. The biggest fear is unemployment and despite the encouragement to spend many consumers may in fact prefer to save.

So where do we invest amongst all of this? Well to answer that, it is worth considering the behaviour of investors in a recession. A survey undertaken by YouGov Alpha illustrates how and when the consumer tightens his/her discretionary belt. When times are tough people become more frugal, a nation full of bargain hunters. The supermarkets have already noticed their customers opting for less expensive food in their ‘value’ range. Indulgence is avoided as people become more prudent in their shopping habits. There will be winners and losers in this environment. Whilst demand will contract for many, for some providers there is less competition. In fund management separating the wheat from the chaff is the role of the stockpickers, there are number of quality UK fund managers that we, at North have identified who I believe have the ability and experience to excel in these markets.

Source: The Alpha Bulletin, Issue 6 YouGov Alpha

I am also keeping a close eye on where the Government and the Bank of England will be directing their capital. When they provided funds to the Banks, the beneficiary was the UK Gilt market. Yields in this market may now be fairly unattractive but there may still be room for further capital gains. If quantitative easing were to occur, then according to Mr King, the Bank of England would consider buying corporate bonds. These would of course be purchased at the higher quality end of the spectrum where the spreads have risen considerably over gilts as a result of the credit crisis. In our portfolios, where appropriate, we now have a significant weighting in quality corporate bond funds managed by some of the leading investment managers.

If you know where to look there will be plenty of opportunity to make money in these markets. The behaviour habits of investors will of course change. Savers will begin to consider whether their deposit account, offering a very paltry rate of interest, is really the best place for their assets. They will look to find other ways of obtaining a relatively safe and reliable income. I very much doubt that they will be interested in returning to the highly complex and leveraged products that we saw so many of in the last few years and which led to this crisis in the first place. A move into more risky assets may well be required but so is the necessity to keep the approach simple. If this is, as I believe, the case, then quality corporate bond and UK equity funds should benefit.

John Husselbee
26th January 2009

Keep following the Fundamentals

It was George Soros, the trader that made a fortune betting against the British Pound in 1992, who once said “short term volatility is greatest at turning points and diminishes as a trend becomes established…” Volatility remains a key feature of today’s financial markets with investors not knowing whether to squeeze the trigger or pull the plug. The market’s daily ups and downs are not driven by fundamental factors but rather by emotion. The VIX, the Volatility Index, is the gauge most widely accepted as the best indication of investor’s risk appetite. It measures the market’s expectation of short term volatility of S&P 500 Index. Commonly referred to as the index of fear and greed, it provides scale of ‘fear’ from zero to hundred. On average, it hovers around 20 or below. This is the level where investors are considered to be relatively confident about the future. Throughout this recent credit crisis we have seen this indicator reach record heights of 80 and above.

As the pendulum of fear and greed swings, it allows the extremities to be reached as investors become too optimistic in bull markets and too pessimistic in bear markets. As the markets go through cycles so too does investor behaviour. This is illustrated by the investor psychology cycle diagram below which was produced by South African based RMB Unit Trusts.


Before trying to establish what stage of the cycle most investors find themselves in this current market situation, let’s consider each of the stages.

Contempt: According to the cycle, a bull market typically starts when a market is at a low and investors scorn stocks.

Doubt and suspicion: Investors try to decide whether what they have left should be invested in a safe haven such as a money market fund. They have burnt their fingers with stocks and often vow never to invest again.

Caution: The market then gradually starts showing signs of recovery. Most investors remain cautious, but value investors began to scoop up the bargains.

Confidence: As stock prices rise, investors’ feeling of mistrust changes to confidence and ultimately to enthusiasm. Most investors start buying their stocks at this stage.

Enthusiasm: During the enthusiasm stage, prudent investors are already starting to take profits and get out of the stock market, because they realise that the bull market is coming to an end.

Greed and conviction: Investors’ enthusiasm is followed by greed, which is often accompanied by numerous IPOs on the stock market.
Indifference: Investors look beyond unsustainably high price-earnings ratios.

Dismissal: As the market declines, investors show a lack of interest that quickly turns to dismissal.

Denial: Then they reach the denial stage where they regularly affirm their belief that the market definitely cannot fall any further.

Fear, panic and contempt: Concern starts to take a hold and fear, panic and despair soon follow. Investors again start scorning the market and once again they vow never to invest in stocks again.

In order to determine where we are in the equity market cycle, it is important to understand where investors are in this psychological cycle. I would argue that we are on the left hand side of the cycle, but where exactly is a matter of personal judgement. I believe that it is likely that investors currently fall into the area of “Doubt & Suspicion.” It is my opinion that the later cycle stages of the right hand side of this chart have already been seen back in September and October. This is when we saw mass deleveraging. Monies have now been temporarily parked on the sidelines in cash and short dated government bonds, which are offering very little in return.

This simple analysis may help with the obsession amongst investors and market commentators to call the bottom of the market. Falling energy and food prices mean that inflation is no longer a concern and all efforts can focus on promoting growth. The massive amount of monetary and fiscal stimulus that central banks and governments have provided to date is clearly designed to restore confidence as quickly as possible. The markets want to see firm evidence of these measures beginning to work fast but it will take time. We would not expect to see signs of a recovery until later next year and a return to economic growth in 2010. However in the long term we believe equity markets to be a discounting mechanism. Studies have shown that in past recessions equities have started to recover, even whilst economic news is still worsening, around six months before the official end of a recession.

Only time will tell whether we are dealing with a typical investor psychology cycle or not and what the next stage of the cycle for investors will be. However, in order to be a successful investor, it is important to distance yourself from the ‘herd’ mentality and to make objective decisions based on the fundamentals. To quote Warren Buffet “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”


John Husselbee
2nd December 2008