19th January 2009

Life below Zero

The actual importance of interest rates at these levels frankly has all the relevanceof two follically challenged men bickering over a comb. Last week’s UK rate cut may have been of some use in filling up news time but served little, other than to distract attention away from some of the other more pressing issues which our financial and political leaders need to be addressing.

The reality of course is that rates have reached a base level where costs of loans and mortgages in effect can’t get much lower and, whilst reducing the costs for borrowers - and especially mortgage holders - can ease the pressure on the indebted, just cutting rates on its own is a very simplistic tool if you are trying to re-ignite the economy.

First of all this policy directly excludes a much larger, and some would say far more responsible, constituency of people who have prudently obeyed all the rules and responsibilities as good citizens – and saved their money. Ordinary cash savers, who are often from an older generation, will have seen their interest income collapse by some 80% over the past year, and yet in the name of “avoiding a recession” as our politicians tell us, they have now been pummelled down into income levels of the poverty stricken. One can easily understand not only why they are so angry but also their question of why they bothered to obey the rules. This then gets to the heart of the matter - that politicians seem incapable of seeing the larger picture and thus not apparently being able to effectively address some of the root issues.

Economies run on trust and confidence. So whether it is banking and borrowing, spending and saving or just investing - if you have no confidence in the system and its operations then you are not going to join in. So what can induce a return to at least some shred of trust? The answer lies with real asset values and for most in the UK that will mean their houses.

However, at present the seemingly continuous flow of dismal property valuation surveys serve only to encourage the regular rants by the journalists and commentators that all property owners are doomed to be in a “slough of despond” for years to come. Such stories may make great headlines but in fact are far more damaging to public morale and confidence.

The facts are that most of these surveys are based on actual transactions and, given that there are barely any house sales going on at the moment, means that the data is at least unreliable if not actually misleading. Those who are selling are generally those who are in the odious position of being a forced seller in a bad market. The poor situation is only further compounded by the fact that there are few buyers and even those that want to buy find themselves in a far more difficult position when trying to find the necessary finance and mortgage agreements.

All we do know is that property valuations were too high and that they would inevitably fall back to their longer term mean at some stage, no doubt overshooting initially on the downside. Also a quick look at the longer term graphs would simply reveal the not unsurprising view that only those who had bought in the past three or four years at inflated prices were likely to be affected – and even then – if that is the primary living dwelling, such paper losses are totally irrelevant if they are planning to stay there for the national average of now over eleven years.

The next issue of trust and confidence comes back to the lending procedures and structures. Blaming banks for everything is an easy (and even sometimes appealing) excuse but “responsible” bankers are not going to lend enthusiastically in a weakening economy.  In fact they are far more likely to be doing the opposite, especially if they are having to be tight on credit and capital.

So to address this, the Government has to introduce a far broader mechanism of government guarantees to provide the banks with the confidence and “comfort” that they can effectively lend against. This in effect is the extension of bank nationalisation (of policy at any rate) which I have mentioned before and is, in my view, now inevitable if confidence is to be established in any short order.

So what should we as investors now do in life at zero or below zero interest rates (in real terms after inflation many rates are of course already below zero)? Cash is obviously not going to be attractive and anyone offering exceptional wonderful rates needs to be regarded with some greater suspicion – Harry Potter does not do banking. Equities are going to be volatile and unreliable friends and many other asset classes will suffer from the falling demand of a global recession. It seems therefore that fixed interest bonds may well be the area of greatest safety but even here there will be fears. US Treasuries and UK Gilts are going to be produced faster than photocopier paper over the next few years, but high quality corporate bonds may well be the area of greatest confidence. This comes down to the issue again of real assets with real value – in life below zero you need to wrap up tightly with a real winter woolly, not a picture of one.

And speaking of dim politicians – Western Europe’s leaders have brilliantly walked into the Bear Trap of Russian Gas. Thank heavens for Norway and Milford Haven otherwise we in the UK would be having an even chillier time than we are now. Once the Ukrainians and Russians have sorted out their billing problems (haven’t they heard of standing orders?) I hope the politicians don’t assume that the risk has gone away. Let this be a lesson to us all to show how easily the light and heat can be switched off – by someone else.

And finally... having trouble with new safety regulations? Then try the Nigerian initiative to get around new motorcycle safety laws regarding helmets. Apparently putting motorcycle helmets on has increased concern over fears of skin disease and a dread of being put under a black magic spell!

So, any alternatives? Firstly you can always try and rent a builder’s helmet – going rate currently 500 Naira (£2.42) per day. These may be somewhat dirty but have limited magical abilities. However, more popular have been dried fruit shells and also saucepans – presumably non-stick would be preferable.  The magical power of Teflon may be the answer.

Have a good weekend,

Justin A. Urquhart Stewart
Director
Seven Investment Management Limited