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Volatility… but value too in UK, says HAMISH MCRAE

Volatile: History does not tell us which companies will fail and which will manage

Volatility…but UK market offers at least decent value, if not better value than much larger US market, says HAMISH MCRAE

Oh dear. Every time UK stock prices manage to hit a new high, something happens and hits them on the head. Thus, the FTSE 100 index, after reaching 8,047 in intraday trade last month, fell to 7,336 before closing at 7,405 on Friday.

This trade bottom was a drop of just under 9% from the high, so not quite a technical “correction,” the word used to describe a 10% drop. But it’s an unpleasant reaction to lingering fears about the stability of the global banking system, and there could be more trouble ahead.

For once, however, the gloom is imported. Several US banks are in trouble, including Silicon Valley Bank. Credit Suisse was rescued somewhat controversially by rival UBS.

Deutsche Bank shares were under pressure, at one point falling 14% before recovering a bit. Unsurprisingly, UK bank stocks also fell, but I really don’t see any big UK banks in trouble. Deposits are pouring in from the UK side of SVB, after it was rescued by powerhouse HSBC earlier this month. In tough times, there is something to be said for having banks that are well capitalized, profitable, prudently managed – and big.

However, you don’t get a sudden drop in share prices without there being fundamental concerns about the global economy, and companies in the Footsie derive three-quarters of their profits from outside the UK. The real question, therefore, is to what extent these concerns are well-founded. Let’s try to unpack them.

Volatile: History does not tell us which companies will fail and which will manage

Volatile: History does not tell us which companies will fail and which will manage

First, there is the fear that central banks will push interest rates up too far, or at least too quickly, which will put serious pressure on the banking system in a way that cannot be entirely planned. Having made the mistake of not taking the inflationary threat seriously and delaying action, they are now overcompensating.

There is something in there. Rates in the US and UK are likely high enough to bring inflation down to an acceptable level by the end of the year.

Last week’s increases of 0.25% by the Federal Reserve and the Bank of England may have been a mistake. A potential borrower always has to deal with two considerations: what is the interest rate and can you still get the loan? If it’s hard to borrow money and credit conditions tighten as banks fret, you don’t need higher rates to stifle demand.

But even if those increases were a mistake, it seems strange to feel sorry for a 0.25% increase. Central banks can always reverse policy. This rise in the consumer price index here at 10.4% will, I think, be an outlier. If inflation falls even faster in the fall than the Bank of England expects, then we could be back to, say, a 3% Bank Rate by Christmas. The second group of worries 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 business failures, and history tells us that this always happens when interest rates rise. Unfortunately, history does not tell us which companies will go bankrupt and which will manage, bloody but rebellious. At this stage of the cycle, there are always unpleasant surprises.

The third concern is more general. It is that there will indeed be some kind of global recession, and that will undermine corporate profits. As far as the UK is concerned, the clouds have lifted a bit in recent weeks – in fact, as I expected. Andrew Bailey, Governor of the Bank of England, now thinks we will escape recession this year. The latest retail sales figures are quite strong and purchasing managers’ indices are forecasting some growth, led by services.

This all adds up to a solid season of reporting from Footsie’s largest companies, several of which have increased dividends and/or announced share buyback programs. You don’t increase your dividend if you’re not confident about earnings in the coming year.

But there is at least a possibility that the turmoil in the US banking sector will push the US economy into recession. Brett Nelson, asset allocation guru at Goldman Sachs, put it this way: “We consider the case for a recession to be about as compelling as the case against it.”

Hmm. My view is that while the “correction” may take a long time to go, you can never find the right time. The UK market offers at least decent value, if not better value than the much larger US market.

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