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Selective hearing

Created:
12 August 2008
Written by:
Mr Bearbull

Auntie Daphne stayed at Bearbull Towers last week - not the most stress-free week in the year. Her chief characteristics are an almost touching reverence for the views of Mary Whitehouse and incredibly selective hearing. So much so that, talk to her about anything vaguely connected to her extensive investment portfolio, and she effects a nonagenarian stupor. Yet whisper the mildest blasphemy within a 20-foot radius of her armchair and her response is a sharp: 'Please, I didn't come here to listen to that filth.'

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Equity markets respond in much the same way to news that they do or don't want to hear. Go back just a few weeks and all they could hear were messages of undiluted misery. Either something was bad and would get worse. Or, it had got worse, so we might as well all go home. But, as July gave way to August, the selective response mechanism seems to have shifted profoundly.

First, Russia announced that it was forming a state-controlled company to manage the export of half the country's grain exports. In one swipe, this combined two of the West's most feared spectres - impending food shortages and the aggressive Russian bear. So it should have sent markets into a tail spin. After all, Russia is a major grain exporter. Yet the markets responded with equanimity - share prices rose on the day and commodity and oil prices continued the decline that started in July.

Now there is a new version of a familiar but no less feared combination - Russia and threats to the West's energy supplies. Of course, I am talking about Russian military intervention in the Georgian territory of South Ossetia. The implication here is that, if the dispute spreads, then that would endanger the so-called BTC oil pipeline, a 1,000-mile pipeline that straddles Georgia, taking crude oil from the wells of the Caspian Sea to Mediterranean Sea terminals in Turkey.

The BTC pipeline could be of crucial significance to Europe's oil supplies because it can transport 1 per cent or so of the world's daily requirements for crude oil. So, even the threat of it being damaged could send the oil price heading back towards $150 a barrel and equity investors diving for cover. Yes, except that it has not been attacked yet - though there are rumours that Russian jets have targeted it. More relevant, the pipeline won't reach full capacity until next year and is barely pumping any crude oil currently because it has been sabotaged in Turkey.

If, therefore, the importance of BTC pipeline is more symbolic than real, that might explain the markets' calm response to Russia's aggressive foray. True, I must throw in the caveat that South Ossetia is likely to be a fast-moving story, so anything that I say about the markets' composure may look stupid within a couple of days. Even so, the initial response has been admirably measured. Last Friday and on Monday, share prices continued to go up and oil prices down. This, as I indicated earlier, is because the markets seem to have re-tuned their selective hearing. Messages that were being received loud and clear and are now ignored, and vice versa.

And the message now being lapped up is all about recovery - the worst is over, therefore the next trend must be up. This has been substantially helped by the realistic response of UK banks to the credit crunch. In aggregate, the UK’s big five banks reported a £12.5bn fall in first-half profits for 2008, most of which stemmed from writing down doubtful assets. Their willingness to accept that the value of so much securitisation is worth little without the interest payments to back it up is commendable. At the very least, it is excellent public relations - it implies that the banks are being run by battle-hardened realists, not deluded wimps.

Yet, arguably, the most battle-hardened - the boss of Royal Bank of Scotland, Sir Fred Goodwin - warned that 'we are nearer the beginning than anything else' when he spoke of the bad debt cycle. In other words, the worst excesses of credit expansion, which started to implode a year ago, have been written down. But we have still to see the remorseless dribble of bad debts across the whole spectrum of bank lending that will follow. These will mean poor results from clearing banks for the next couple of years even if headline profits are no longer falling.

Something similar will apply across much of the equity market - the worst hits to profits may materialise in 2008, but these are likely to be followed by poor returns on capital and deteriorating cash flow until 2010 at least.

So those investors who have dashed into shares in the likes of Barratt Developments, Taylor Wimpey, Johnston Press and Trinity Mirror this month are gambling. If their investment horizon is at least five years and they can live with nasty book losses along the way, they may well make decent returns. And this is a course that I, too, may follow before the summer is out.

On the other hand, there is still much to be said for the investment plan advised by Auntie Daphne’s stock broker in Eastbourne. 'I can't understand it,' she complains. 'He's a nice young man, but he says I should be buying nonsensicals.'

'I think he means non-cyclicals,' I try to tell her. But it's no use. Aunt Daphne is as stubborn as a stock market - she only hears what she wants to hear.

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