Markets reach record highs but are investors brushing fears under the carpet?

Oct 10 2007 by Haydon Wood, Liverpool Daily Post

WHEN the credit crisis sent stock markets tumbling around the globe during August, traders would have given very long odds on some recovering to record highs just six weeks later.

Last week, Wall Street’s Dow Jones Industrial Average did just that, reaching an all-time high of 14,087. Hong Kong’s Hang Seng index followed with a record close the next day.

The optimism has spread to London, where the FTSE 100 Index has also climbed sharply higher to “pre-crunch” levels above the 6,500 mark.

The relief has come largely from the same source as the cause of the recent turmoil. While a crisis in confidence over bonds backed by high-risk US mortgage debt caused fearful banks to stop lending to each other in the summer, a 0.5% interest rate cut from the US Federal Reserve has eased recession fears.

The continued weakness of the world’s largest economy, with worse-than-expected housing sales and manufacturing data adding to the gloomy picture, has also supported the Dow as markets anticipate further cuts to interest rates.

The questions over the levels of exposure of major banks to sub-prime mortgage debts – another factor undermining stock markets – were partially answered this week when the world’s biggest bank, Citigroup, braced investors for a 60% fall in third-quarter profits to $2.2bn (£1.1bn).

Swiss giant UBS also expects its first quarterly loss in nine years after writing off £1.67bn following the sub-prime fall-out, and will axe 1,500 jobs in its hard-hit investment banking business.

Citigroup’s share price actually finished higher as the group described the figures as an “aberration”, and both banks said they expect a “more normal” environment in the final three months of the year.

But some experts are far less sanguine about the market outlook, including CMC Markets chief market analyst David Jones, who believes investors are in a state of denial.

He said: “Markets are denying the reality of what we went through in August. UBS and Citigroup are taking a big hit and their shares go up.

“The risk is that the credit crunch continues and these companies have a tough fourth quarter as well.”

While lower interest rates in the US and the prospect of lower borrowing costs at home have given a recent boost to equities, Mr Jones says market confidence is fragile and it would only take a new trigger – another Northern Rock perhaps – to spur a further collapse.

Royal Bank of Scotland economist Kit Juckes added that markets were paying the price for the “monetary madness” of zero interest rates in Japan and 1% in the US four years ago. He said: “Markets continue to behave as though this is a 1998-style crisis – short, sharp and of little lasting economic significance.

“My view is that the reduced flow of money into a slowing US economy, and the knock-on from a softer dollar and reduced capital market largesse, will result in significantly slower growth globally.”

Exchanges may also have further to fall as leading stocks once fancied as takeover targets lose their “bid premium”, as private equity firms lose the ability to raise funds for merger and acquisition activity. For example, Dairy Milk maker Cadbury Schweppes has fallen around 20% over the same period as the group was forced to postpone the sale of its US business as bidders failed to meet the £8bn asking price amid the debt crunch.

The private equity deals that are still going ahead are on a far less ambitious scale than the £11bn deal that saw high street giant Alliance Boots bought earlier this year.

Buyout houses are now targeting the likes of mid-caps such as oil firm Abbot and crane hirer Ainscough.

So why is the FTSE heading so quickly back towards the seven-year highs seen in mid-June before the crunch bit?

Richard Hunter, head of equity analysis at stockbroker Hargreaves Lansdown, is sticking with predictions that the FTSE will hit 7,000 by the end of 2007 – setting a new record high.

“At the moment, there is nothing to suggest a massive slowdown in corporate earnings, and firms will also be reaping the benefits of belt-tightening following the dotcom crash at the turn of the century,” he said.