The news over the weekend that the erstwhile venerable institutions, Lehman Brothers and Merrill Lynch had ceased to exist – the former filing for bankruptcy and the latter being “absorbed” by Bank of America - hit the markets hard when they opened for trading yesterday. And with insurance giant AIG also struggling to raise funds (and its share price plunging 63% as a result), the 100 index ended the day down 3.9% whilst the Dow Jones Industrial Average had its fifth worst day on record as it lost 4.4% of its value. Today there have been further losses in London with the Blue Chip index down another 3% at the time of writing in response to overnight losses of 5% in both Hong Kong and Tokyo.
The response from the monetary authorities has been swift and decisive in their attempts to minimise the fallout. The Federal Reserve has increased the size and range of assets it will accept as collateral in return for liquidity under its Term Lending Securities Facility, the Bank of England has pumped £5bn of extra funds into the money markets, whilst the ECB has allotted £24bn in one-day liquidity. On top of this, and in light of the Fed’s decision to allow Lehmans to go to the wall, ten of the world’s biggest banks have agreed to set up a $70bn fund to provide emergency funding to any one of them as and when required. However, it is unclear whether such action will be sufficient by itself to stabilise conditions in the global equity markets; if Lehmans and Merrill Lynch can go under, then who might be next? Certainly, the immediate reaction from investors has been to demand a substantially higher risk premium in order to hold equities, and in particular financial stocks.
Dividend yields will be higher than they otherwise would have been, and this looks likely to remain the case until the financial institutions have repaired their balance sheets sufficiently in order to restore confidence. This in turn means more capital-raising. Unfortunately, the flip side of this necessary but painful adjustment process is that it will exacerbate the hoarding of cash across the sector and therefore further depress the supply of credit to non-financial companies and consumers. In other words, wholesale market interest rates will rise, increasing the already huge downside risks to the real economy.
In order to prevent what was in any case going to be a difficult next 12 months for the world economy from turning into a 1930’s style slump, it is imperative to break the vicious downward spiral of falling property prices leading to more banking sector writedowns, further balance sheet repair and then even greater reluctance to lend. This can only mean decisive cuts in policy interest rates. The People’s Bank of China recognised this and acted accordingly yesterday, and the smart money reckons that the Federal Reserve will do likewise this evening, bringing its target rate down to 1.75% or even lower. In recent months, both the ECB and the Bank of England’s Monetary Policy Committee have been too concerned by the inflation risk to take pre-emptive action to support the real economy. But that was before the oil price had fallen by more than 50% in just over a month. True, UK CPI inflation hit 4.7% this morning and may even yet touch 5% in September, but after that it is going to plunge, dropping back beneath 2% by the middle of next year before falling further in the second half of the year. Indeed, barring a sudden reversal in the oil price, the MPC’s biggest concern in the year ahead will be preventing inflation from undershooting its target by more than 1%. Consequently, we now expect the MPC to relax policy at its meeting in early October, with interest rates falling as low as 3.5% by the end of 2009.
Provided this happens, happier days lie ahead for equity market investors. We cannot deny that it will be a bumpy ride in the coming few months as the banks try to sort themselves out. And just because we believe equity markets are cheap at the moment doesn’t mean they can’t get cheaper still in the near term. However, as falling interest rates lead investors to look ahead to the next cyclical upswing (which will happen despite the current pessimism) equities will rally. Long term investors who can afford to ride out the short term volatility should consider adding to their holdings.