Jeremy Warner's Outlook: More rate cuts loom as credit crisis bites

Compass seems to have turned corner; Bettington hits ejector seat at Biffa; DSG gets its man but trouble looms
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What in September was still looking as if it would be only a temporary financial storm with relatively limited consequences for the real economy has turned into something much more drawn out and potentially damaging.

In apparent recognition of the point yesterday, Don Kohn, vice-chairman of the Federal Reserve, said the US central bank was prepared to be "flexible and pragmatic" in its response to renewed stress in the credit markets. The credit dislocation looked as if it might be abating a month or two back, but now seems to be returning with enhanced vigour.

The markets naturally took Mr Kohn's remarks as a hint of more interest rate cuts to come, never mind that still quite pronounced inflationary pressures seem severely to limit the Fed's room for manoeuvre. Yet if the economy is slipping into recession, or at least fast decelerating, that in itself ought eventually to lead to lower inflation, giving policymakers the leeway they need to take the foot off the monetary brake.

If only it were that simple. The problem central bankers have got is that they don't yet know how severe the effect of the credit crunch on the real economy is going to be. Will it be a big effect, or just a little one?

Banking crises usually post-date the downturn in the economic cycle. Typically, they occur when recession or lower economic growth cause borrowers to start defaulting. What makes this banking crisis almost unique in the modern age is that it is not on the lending side of the balance sheet that the problems are occurring, but rather in the funding of that lending.

Up until recently at least, the macro-economy looked in reasonable health, even in the US. In Britain, there is as yet no problem of bad debts or rising unemployment, as there was in the last big banking crisis of the early 1990s.

That's not to say that the credit crunch is occurring in total isolation of events in the real economy. The macro-economic backdrop is the US housing cycle, which as a consequence of overlending in sub-prime markets is experiencing a vicious downturn. The lightning conductor through which this is being conveyed into the wider world economy is the global financial system.

Losses on sub-prime lending have put banks the world over in defensive mode. As banks move to protect their capital, credit has become scarcer and more expensive. None of the big international banks are in any obvious danger of being sunk by the crisis. HSBC's ability to swallow its entire Structured Investment Vehicle exposure without having to raise more capital demonstrates just how robust most of these big banks really are. Similarly, Barclays has been able to reassure with news of record profits despite writedowns on sub-prime securities and leveraged finance.

Yet if nobody is lending to bankers, bankers cannot lend to anyone else, and with many of the mechanisms that fed the credit boom of recent years now closed, or severely scaled back, a quite significant contraction in banking balance sheets now seems inevitable. As far as the British economy is concerned, conditions were already showing signs of responding to the tighter monetary conditions imposed earlier this year even before the credit crunch hit. At first, it was thought the credit dislocation would be a relatively short-lived affair, a bit like the financial crises of 1987 and 1998, which with policy action by central bankers quite quickly abated.

Yet this particular crisis is proving a more sustained fire-storm. Things have got tighter still in the last few weeks, and it is now clear beyond doubt that the stresses will not be going away for some months yet. The longer it lasts, the more serious the consequences for the real economy. Even in Britain, there is still some possibility of an interest rate cut before Christmas. If they are coming anyway, what's the point of delaying.

Compass seems to have turned corner

Richard Cousins has pulled off a remarkable recovery in the affairs of Compass Group since he joined the previously bombed-out contract caterer as chief executive 18 months ago. He was an interesting choice when appointed in May last year, as his business experience up until this point had been almost entirely in the plasterboard industry. It is hard to imagine an activity more far removed from catering than construction materials. Yet he seems to have gripped the business, done the necessary and is already reaping some early rewards.

Full-year results announced yesterday show 5 per cent organic growth in revenues, a 16 per cent rise in operating profits, a 70 basis-point increase in margins and, most important of all, a 68 per cent uplift in free cash flow. There was always a suspicion with Compass that much of the declared profit was more of an accounting illusion than real money in the bank.

True or not, by disposing of non-core businesses, stripping out working capital and driving through gains in productivity, Mr Cousins has succeeded in converting a lot more of those profits into hard cash than has been the case for an awfully long time now.

Yet it is perhaps the case that Mr Cousins has only done the easy bit so far. For obvious reasons, a large part of Compass's costs are food, where prices are inflating a good deal more rapidly than they can be passed through to customers. Dollar weakness is depressing earnings from America, which accounts for nearly half of the company's revenues. A fast slowing US economy makes for further challenges still in the year ahead.

Still, Mr Cousins might reasonably reflect that, in an economic downturn, catering is a better place to be than plasterboard. Goodness knows what's happened to BPB's US sales since Mr Cousins sold the company to France's Saint-Gobain for a top-of-the-market price two years ago.

It's an impressive start he and Sir Roy Gardner, the chairman, have made at Compass. Let's hope they can keep it up.

Bettington hits ejector seat at Biffa

Martin Bettington is stepping down as chief executive of Biffa only a few days after the company confirmed that it had received and rejected a takeover approach from Montagu Private Equity and HG Capital, thought to be at 325p a share.

There is no obvious explanation for his departure other than 17 years is an awfully long time to be working in waste disposal. The fact that Mr Bettington will get eight months' pay by way of compensation suggests his going is not entirely voluntary. In any case, to jettison both the management and the bid at the same time is a pretty odd thing to have done. A credible explanation is called for.

DSG gets its man but trouble looms

DSG International, the former Dixons, has bought itself an excellent new chief executive in the form of John Browett, a Tesco high flyer, but he is not starting in the most auspicious of circumstances.

The Currys and PC World electricals retailing group has reported a drop of a quarter in underlying half-year profits, and is extremely cautious about the outlook for Christmas and the new year. Problems in Italy, and lacklustre demand for Microsoft Vista, which left PC World with huge numbers of unsold laptops, have severely undermined earnings.

If Mr Browett thought he was coming in to run a FTSE 100 company, he should think again. DSG is almost certain to fall out of the index at next week's adjustment of constituents. Big-ticket items such as flat-screen TVs have been a lifeline for DSG as the retail market has begun to slow. It is hard to see how they can be unaffected by the growing credit squeeze.

Mr Browett earned his spurs helping to build Tesco into the largest online retailer in the country. That's where a large part of DSG's future lies too. But it is going to be a decidedly rocky first year or two for the new man.

j.warner@independent.co.uk

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