Volatility… but value too in UK, says HAMISH MCRAE

Oh dear. Every time UK stock prices manage to hit a new high, something comes along that knocks them upside down. So the FTSE 100 index, which had risen to 8,047 in intraday trading last month, fell to 7,336 before closing at 7,405 on Friday.

That trading bottom was a drop of just under 9 percent from its peak, so not really a technical “correction,” the word used to describe a 10 percent drop. But it’s a dire response to lingering fears about the stability of the global banking system, and more trouble could come.

But for once, the gloom has imported. Several US banks have run into problems, including Silicon Valley Bank. Credit Suisse has been rescued in a somewhat controversial manner by its rival UBS.

Deutsche Bank shares were under pressure, down 14 percent at one point, but recovered somewhat. Unsurprisingly, UK bank stocks have also fallen, but I really don’t see any major UK bank in serious trouble. Deposits are flowing back to the UK side of SVB, following the rescue by the powerful HSBC earlier this month. In difficult times, there is something to be said for banks that are well capitalized, profitable, conservatively run and large.

However, you don’t get a sudden drop in stock prices without some fundamental concerns about the global economy, and the companies in the Footsie derive three-quarters of their revenue from abroad. So the real question is to what extent those concerns are justified. Let’s try to unpack them.

First and foremost, there is the concern that central banks are raising interest rates too far, or at least too fast, and that this will strain the banking system in ways that cannot be fully foreseen. Having made the mistake of not taking the threat of inflation seriously and delaying action, they are now overcompensating.

There’s something in that. Rates in the US and UK are now probably high enough to bring inflation back to acceptable levels by the end of this year.

Last week’s increases of 0.25 percent by both the Federal Reserve and the Bank of England may have been a mistake. There are always two considerations that a potential borrower faces: what is the interest rate and can you still get the loan? If it’s hard to borrow the money, and credit terms are certainly getting tighter because banks are concerned, you don’t need higher rates to stifle demand.

But even if those increases were a mistake, it seems odd to speculate on a 0.25 percent increase. The central banks can always reverse policy. That increase in the consumer price index here to 10.4 percent will, I think, turn out to be an outlier. If inflation falls even faster in the autumn than the Bank of England expects, we could go back to, say, 3% bank rates by Christmas. The second group of concerns is that behind the loss of confidence in some of the weaker banks is the fear that too many of their customers are in trouble.

There will be corporate failures and history tells us that they always happen at a time of rising interest rates. Unfortunately, history does not tell us which companies will fail and which will scramble through bloody but unyielding. There are always nasty surprises at this stage of the cycle.

The third concern is more general. It is that there will indeed be a kind of global recession, and that this will undermine corporate profits. As far as the UK is concerned, the cloud cover has lifted slightly in recent weeks – as I expected, in fact. Andrew Bailey, Governor of the Bank of England, now thinks we will escape the recession this year. The latest retail sales numbers are quite strong and purchasing manager indices are forecasting some growth, especially in the services sector.

All of this comes on top of a solid reporting season from the largest Footsie companies, several of which have raised dividends and/or announced share buyback plans. You don’t increase your dividend if you don’t have confidence in earnings in the coming year.

But there is at least a possibility that the US banking turmoil will push the US economy into recession. Brett Nelson, asset allocation guru at Goldman Sachs, put it this way: “We see that the arguments for a recession are about as compelling as those against a recession.”

Um. My view is that while the ‘correction’ has a long way to go, you can never get the timing right. In any case, the UK market offers decent value, even better value than the much larger US market.