Jeremy Warner's Outlook: Bear market that dares not speak its name

Italian flavour to LSE Christmas lunch
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It's just as well all those mining finance houses decided to come and list in London. Without the bulk they have added to the FTSE 100 and All Share indices, we would be in a quite serious bear market right now. As it is, the FTSE 100 is less than 5 per cent off the year's high achieved in July just before the credit crunch began to bite, and still up on the year as a whole.

Yet behind the big numbers, there are some extreme sectoral divergences. On one side of the see-saw, there are the mining and oil companies, buoyed by high prices and seemingly insatiable demand from booming emerging markets. The miners have also developed a penchant for taking each other over, so there's M&A to add to the excitement of the sector too.

Somewhere in the middle lie telecoms, utilities and pharmaceuticals, all defensive stocks attractive to investors as they batten down the hatches in preparation for possible recession. After years in the doldrums, Vodafone, with its stable, cash-generative, income stream and relatively high exposure to the fast growing mobile telephony markets of the developing world, suddenly seems the place to be and its shares have benefited accordingly.

Some of the same observations might be made about pharmaceuticals. Despite extreme pricing pressures in some parts of the world, overall healthcare spending is set to keep rising whether there's a recession or not.

Anything cyclical or with exposure to the consumer side of the economy retail, housebuilding, media, manufacturing is suffering. The mid-cap FTSE 250 index, which is much more reflective of the UK economy than the internationally orientated FTSE 100, is now quite seriously off its yearly peak.

Yet the real stinker is financials banking, insurance, asset management and broking. These sectors have been completely poleaxed, and with good reason as far as banking is concerned. Bankers invented the sub-prime market and are now bearing the brunt of its losses.

They are also the biggest part of the sharp deterioration in the outlook for corporate earnings we have seen since the summer. Back then, buoyant corporate earnings seemed to more than justify stock market valuations, which looked relatively modest against past cyclical peaks. Yet it is of course the case that if these earnings are about to collapse, then the valuations start to look a lot more stretched.

Banking profits are already being hard hit by the crisis in credit markets. HSBC is forecasting a drop of a quarter in financial earnings in the US this year, assuming sub-prime write-downs in the fourth quarter of a similar order of magnitude to the third. In Britain, HSBC is predicting a drop of some 7-10 per cent and in continental Europe around 2 per cent.

Remember, these forecasts of outright reductions in earnings compare with the assumption earlier this year of a substantial rise. The deterioration in outlook is therefore much sharper than the HSBC numbers suggest and seems to more than justify the damage done to share prices in the financial sector. Nor does it seem likely that banking profits will bounce back next year.

The losses incurred in the credit crunch have in themselves substantially damaged the capital bankers have to set against their lending for solvency purposes. What's more, some banks are being forced to take business previously placed off-balance sheet through Structured Investment Vehicles (SIVs) back on to their books, further eating into the amount of capital they have available for new business.

HSBC has already absorbed some $43bn of such assets, while earlier this week Citigroup bit the bullet and brought $49bn of SIV assets back on to its books. In some respects, it shows how impressively well capitalised these banks are that they are able to do this without greater recourse to the markets for fresh capital.

Yet the bottom line is that there will be less capital for new business next year, which means the amount of credit available may shrink rather than continue to expand, as anticipated until only a few months back. Less business means lower fees and squeezed profits. The credit boom produced a profits bonanza for the banks. That source of buoyancy in earnings is now closed off.

The wider outlook for corporate earnings beyond the banking sector is also looking a good deal less benign. Scarcer credit means less money for business expansion, and if the consumer economy heads south then there is bound to be a sharp deterioration in earnings prospects for a whole raft of sectors from retailing to business services and manufacturing. Already, many business leaders are looking with a critical eye at their IT and marketing budgets in preparation for tougher times to come.

Even going back 10 years and certainly 20, banking used to account for a much smaller part of stock market value than it does now. The credit boom in combination with the explosive growth of investment banking made it much bigger than it used to be. Bears of the sector characterise the current meltdown as no more than a return to norm after the "aberration" of recent years.

Perhaps they are right, and certainly there seems little prospect of a recovery in banking shares any time soon. Yet in the longer run it seems to me to be a mistaken argument. Banking has again proved itself to be a quite high-risk activity, yet unless you think that the world economy is going to stop growing permanently, with the development story of emerging markets halted in its tracks, then overall demand for its services will over time continue to rise exponentially as the weight of wealth looking for a home grows.

There is no guarantee bank stocks will recover any time soon, but, on any long-term view, they already look hugely oversold. Kevin Gardiner, head of equity strategy at HSBC, likens their plight to the reverse image of what happened during the dotcom boom. Back then, crazy technology valuations were justified on the basis that there would eventually be a small number of winners which would outweigh the losses sustained on the losers. Paying top dollar for a portfolio of largely worthless bric-a-brac could therefore be justified on the basis that one of them might be the next Microsoft.

Mr Gardiner sees much the same phenomenon in the very low valuations being assigned to banking and insurance stocks. The fear that one of their number might be the next Northern Rock has caused investors to shun the sector en masse. As with the dotcom boom, it will take some while before this psychology starts to shift. This is not the moment for swimming against the current. The negative news flow is too powerful to allow for a meaningful bounce in markets for the immediate future.

Yet as the US economy begins to move into recovery mode from the middle of next year onwards, it will be banking that leads from the front in the ensuing stock market surge.

Italian flavour to LSE Christmas lunch

Tommaso Padoa-Schioppa, the Italian finance minister, made an unlikely guest speaker for the Christmas lunch held yesterday by the chairman of the London Stock Exchange. A prime mover in the establishment of the euro, Mr Padoa-Schioppa always thought that a single currency region demands a unified stock exchange and he long lobbied for the Italian stock market to be merged with Deutsche Brse in Frankfurt.

In the end, however, he was forced to agree to its takeover by the LSE. The ability to choose who you marry, he mused, is a comparatively recent phenomenon which has yet to demonstrate it has any merit over the tradition of arranged marriage. It was plain that he, the father, would have preferred to choose Borse Italiana's marriage partner himself.

Still, he may be coming round to his miscreant daughter's choice of groom. In what was apparently a first for Mr Padoa-Schioppa's visits to London, the LSE chairman, Christopher Gibson-Smith, managed to get the pronunciation of his name right. This is something we are all going to have to master now that we have an Italian as the new England manager.