Lloyds Trading the Chart Thread

Don't do silly things, play safe
By Tony Jackson (Filed: 02/01/2005)


I have always felt that forecasting the stock market a year ahead is a slightly odd enterprise, and I've done it often enough to know.



It might seem all the odder now because the market is so deeply out of fashion. All the action today is in complex derivatives or hedge funds of hedge funds. Equities are drifting sideways on a 3 per cent yield, and are too dull to contemplate.

Perversely, though, that could prove a strength this year. There are scary things going on in the financial world, all stemming from too much money chasing too little yield. If everyone is blowing bubbles, there is much to be said for a market where the bubble has already burst.

What scary things are we talking about?

One statistic to begin with. In Europe and the UK last year, corporate bond issuance by non-financial companies nearly halved. But a flood of new issues from the financial sector made up the difference. So while non-financial companies have been drawing in their horns, the banks have been borrowing heavily at cheap rates and looking for silly things to do with the money.

One such silly thing, I suspect, is the private equity boom. The value of deals worldwide last year increased by 60 per cent compared with 2003, and reached about triple the levels of the late 1990s. Of last year's total of $300bn, a fifth was spent in the UK.

Another silly thing may well be commercial property. According to the Bank of England, more than half of all new corporate lending by UK banks lately has been to the commercial property sector. Hence all those gleaming new palaces around the City these days, almost all of them unoccupied.

Or, for a really scary one, try credit derivatives. I have argued before in this column that, properly managed, these are a good thing. But in the scramble for yield, even the best ideas can get out of hand.

One of the building blocks of this trillion-dollar market is the CDO – a basket of loans and bonds. These can be opaque and risky instruments, and therefore carry a higher yield.

Today we have the aptly-name CDO2, which is a basket of CDOs – riskier again, and yielding more accordingly. There is even talk of the CDO3, which is a basket of baskets of baskets. Any investor tempted by this kind of thing should take a holiday in Las Vegas to sober up.

All this stems from familiar causes. Across the financial spectrum, yields remain stubbornly low, despite the fact that the US authorities have been raising interest rates for the past six months. Treasury yields have not responded, and the yield premium on riskier corporate and emerging market bonds has actually fallen.

So investors have responded by cranking up their risk. Nothing has gone bang yet, but something will. And the pressure point in the whole system is the banking sector.

So how robust are the UK banks just now?

Not too bad, says the Bank of England, whose job it is to know. Bad debt provisions are still tiny, profits are high and balance sheets are strong. So the risks of systemic failure are low (though if the Bank said anything different, we would all jump out the window).

But as the Bank also points out, UK banks today are getting less of their earnings from plain old interest on loans. This is a reminder that the banks, besides funding the dodgy doings of others, are also running bigger risks at first hand – for instance, in proprietary trading and working with the hedge funds.

So, back to the equity market. It might seem curious to describe it as a safe backwater, when the banks themselves constitute a large chunk of it by value and an even bigger chunk by dividend income.

But if the Bank of England is right, and systemic damage is not on the cards, all that suggests is that you should steer clear of bank shares.

Other companies, as I said earlier, have mostly reduced their debts and are flush with cash. Some, such as the utilities, even offer a decent yield. So, external shocks apart, I see no reason why the broad market should not remain dependably dull this year – in other words, flat or maybe even up a little.

Even so, there will always be those timid souls – myself partly included – who will prefer to leave their money on deposit. That gets you 5 per cent and no worries. Provided, of course, you pick the right bank.