Guy de Blonay, manager of the New Star Global Financials Fund, analyses the current pressures on financial markets and explains why he expects a recovery during the second half of 2008. The New Star Global Financials Fund is rated 'AA' by Standard & Poor's and the manager is 'AAA' rated by Citywire*. Lipper, the performance group, ranks the fund as the top specialist financial fund in its global database over five years#. The fund returned 196.53% in sterling terms over the five-year period compared to the global average of 60.54%#.
The current year has brought with it challenging trading conditions. While there was weakness in the financial sector in 2007, investors were able to identify the potential problems they faced. An analysis of the situation suggested that they avoid stocks with US sub-prime related exposure, such as investment banks, and retail banks with short-term funding issues, such as Northern Rock. While US and Western European bank shares trended south, financial companies in other regions made gains, notably Turkish and Brazilian banks and Chinese real estate companies.
Where there appeared to be some rationality behind share price movements in 2007, indiscriminate market movements seemed to prevail in the first quarter of 2008. Economic pressures were varied and continue to spread well beyond the banking sector. The high prices of oil and other commodities fuelled inflation concerns and fed through to weaker profit margins in industry. Global economic growth is expected to slow and US sub-prime related problems are forecast to continue through the first half of this year. Distrust between banks remained at the quarter end amid fears that there would be further corporate failures. Bear Stearns was the first to go in 2008 and there are likely to be other casualties. A number of hedge funds and leveraged vehicles assumed a 'zombie-like' state - continuing to operate but effectively dead.
In such conditions, the hands of the long-only fund manager are temporarily bound. The stockmarket's risk-pricing mechanism was knocked out of kilter in early 2008 and the levels of volatility made it easy to get burnt by attempting to play aggressively or trying to be too clever. Stock analysis and the amount of due diligence required has multiplied, with the credibility of analysts' research and company reporting called into question. The resulting lack of trust hinders a fund manager's ability to build and aggressively pursue convictions. In this environment, a focus on preserving capital is prudent.
US and Europe
The US and European markets present different challenges. In the US, much of the pain seemed to be out in the open at the end of the quarter. Fire sales, write-downs and management changes featured heavily and some of the problems were booked into 2007 numbers. The Federal Reserve, while criticised for being behind the curve, was proactive. By providing liquidity to investment banks, altering regulations and policy and overseeing the rescue of Bear Stearns, the Fed ensured the functionality of capital markets. This should pay off as it feeds through in the coming months. The question may now shift to confidence restoration. Hedge funds shoulder some of the blame alongside the banks for the systemic risk and addressing this will help achieve the normalisation of markets.
European banks were slower to put their affairs in order and suffered particularly severe selling. Within the sector, corporate boards proved reluctant to be the first openly to state their exposure to risk for fear of share price falls. This hesitancy left trust between banks fragile if not nonexistent. In turn, the lack of inter-bank lending and the credit drought made economic expansion in the wider economy more difficult. Leadership from central banks was also weaker than in the US, with the Bank of England and the European Central Bank relatively frozen in their tracks. In March, however, there were hints from the ECB that it was becoming more prepared to move in sync the Fed.
Ahead of the rally
While pressures remained at the quarter end, investors had a greater understanding of the problems they faced and further clues about the likely severity of the US slowdown. With a relatively weak economic prospects priced into share valuations, it is possible that surprises will come on the upside rather than the downside.
If the slowdown is mild, as early indications suggest, stockmarkets should bounce back quickly when confidence returns, potentially recovering most if not all the losses suffered in the first quarter. The New Star Global Financials Fund will be positioned to give it the potential to participate in the rally. Once the recovery comes, it is likely to be significant and fast. In late March, institutional investors were sitting on large amounts of cash, which they will be looking to invest. The stocks that lead the climb are likely to be those that have been marked down the furthest - namely financial services companies.
Futures
Until there are indications of a return to health for stockmarkets, the fund will maintain its defensive positioning. About 70% of the fund was in core holdings at the quarter end. The remaining liquidity position included futures in the Dow Jones Euro Stoxx Banks Index used for hedging purposes. These can be turned into cash rapidly and deployed in share purchases, giving the fund the flexibility to move quickly as conditions dictate. The risk of failures at an individual company level appeared high in early 2008. As a sector, however, European banks offered good value, with the Dow Jones Euro Stoxx Banks Index down 18.38% in euro terms over the first three months of 2008†. Futures will be used as an efficient portfolio management tool, reducing risk at an individual stock level. The weighting in futures will typically not exceed 10% and the position will be covered by cash or cash equivalents.
Core portfolio
The core equity portion of the fund at the quarter end was made up of companies that have diversified income streams and solid capital bases. The holdings typically have little or no exposure to US sub-prime and operate in economies relatively free from leverage problems. The fund maintained its exposure to Switzerland, Norway and Sweden but had reduced exposure to the UK and largely avoided Ireland and Spain. Stocks with emerging market growth potential were also favoured, including Standard Chartered.
Investment banks, such as Merrill Lynch and Goldman Sachs, did not figure in the portfolio. The question for these is not necessarily whether there are more write-downs to come but whether they have the ability to write new business over the coming years.
Favoured stocks include Zurich Financial and Generali Group. Both have low exposure to structured finance and are likely to continue to raise dividends and generate high levels of cash. Zurich Financial released strong results in February, highlighting its diversified product mix, organic growth potential and excellent capital management. Man Group, the asset manager, with its high exposure to the structural growth in alternatives and strong performance track record in volatile markets, continued to be a key holding for the fund.
Royal Bank of Scotland and HBOS provide interesting opportunities. These were heavily punished by the market and were among the cheapest banks in Europe on a valuation basis in late March. The question now is whether short-term valuations outweigh longer-term uncertainty. The numbers are being analysed with interest.
The fund's exposure to Turkish banks was cut in early 2008. If the US does slip further, Turkey is unlikely to be able to decouple due to its dependence on exports. The prospects for Greece, however, remained intact, with strong domestic growth forecast and banks reaping the benefits of consolidation. Investing in Greek banks also provides access to the small but fast growing peripheral markets of Serbia, Montenegro and Macedonia.
When confidence returns to the stockmarket, the New Star Global Financials Fund is likely to shift its focus away from diversified companies benefiting from volatility in favour of banks, which have been feeling the cyclical pain. This may lead to an increased exposure to the US, a country in which the fund has been underweight for many years. The valuations of US financial stocks in March were at distressed levels. The steepening of the yield curve, however, suggested that the sector could face a profitable environment once confidence returns. The fund may therefore seek to add opportunistically when conditions are right.
Going forward
While the stockmarket's losses in the first quarter of 2008 presented an attractive entry point, there may be more pain over the coming months. Rather than focusing on daily price movements, a broad view of the financial system is needed to understand how deep the problems potentially are. In these conditions, a cautious approach is sensible and the fund is likely to maintain high levels of cash or cash equivalents for some time to preserve capital and flexibility. If valuations have slipped further by the summer, this may be used as an opportunity to move back towards being fully invested.
Important information
*At 29.02.08
#Source: Lipper, total return, gross, no initial charges, sterling to 29.02.08.
†Source: Datastream, total return, euros.
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