AN INVESTOR'S VIEW:While there are signs that conditions in the wholesale money markets may be improving, the focus of investors' attention is moving to the negative impact of the credit crunch on real economic activity

LAST FRIDAY, the European Central Bank (ECB) published the results of its most recent bank lending survey. The survey showed that during the first quarter there was a further tightening in credit standards for loans to enterprises, and for house purchase and other personal loans.

Furthermore, it pointed to the likelihood of more tightening in the second quarter, although the extent of further tightening was expected to be somewhat less than in the first quarter. This is consistent with developments in the real economies of Europe, where tightening credit conditions are beginning to eat into economic growth.

In the Republic, recent economic indicators paint a picture of an economy that is still growing, but growth momentum is slowing across most sectors.

In the first quarter, industry grew by 2.5 per cent year-on-year, which is a good performance in the current environment. However, the prospects for the rest of the year are deteriorating due to the appreciating euro and slower growth in our export markets.

Housebuilding activity remains in steep decline and the bottom of the market is not yet in sight.

A bigger threat to the more optimistic economic forecasts comes from evidence that consumer spending could be about to slow appreciably. Consumer spending accounts for 50 per cent of gross domestic product (GDP) and therefore any deterioration in it will have a major impact on the overall GDP numbers.

Retail sales growth is viewed as a good indicator of overall consumer spending, and the data for February was weak. Given that car sales were poor again in March, it is likely that the March retail sales data will show further weakness. Anecdotal evidence from retailers points towards a potentially sharp fall-off in spending.

Economists' forecasts of real GDP growth for 2008 have been gradually revised down as the year has progressed and most forecasts now reside in the 2-3 per cent range.

However, if the weak trends evident from the more up-to-date measures of activity persist for much longer, these economic forecasts will have to be revised down further.

A slowing economy and tightening lending standards point towards an inevitable increase in bad debts for the banking system.

Brokers' forecasts of bank profits already factor in a significant deterioration in bad debts over the next two years at the Irish banks. Therefore, there is a reasonable chance that the current depressed bank share prices discount this expected deterioration in the bad debt cycle.

Clearly, deteriorating conditions in the real economy present investors with a good reason to continue to avoid investing in financial stocks.

However, on the positive side, there are some early signs that conditions in the wholesale money markets may be improving. The ECB survey reported that banks expected some improvement in their access to wholesale funding in the second quarter. However, the banks surveyed indicated that conditions were tough during the first quarter, as they had increased difficulty in accessing wholesale funding, particularly over the medium to longer term.

Another potentially significant development was the news that private equity manager BlackRock had struck a deal with UBS to buy a $15 billion (€9.7 billion) portfolio of distressed debt for 75 cents on the dollar. This is a large discount, but the fact that a deal of this magnitude occurred indicates that the market may be finding a floor. This may encourage further deals, which would inject badly-needed liquidity into the system by freeing up banks' balance sheets.

There is in fact a small but growing number of investors who are prepared to make contrarian bets on distressed portfolios of mortgages.

These include Goldman Sachs, TPG and other investment banks, as well as some private equity firms and hedge funds. A key benefit of these deals is that they establish a market-based estimate of the valuation of these mortgage portfolios.

One of the many factors serving to prolong the credit crunch is the difficulty in valuing mortgage portfolios and the opaque securities where the underlying assets consist mainly of mortgage-backed portfolios.

Developments such as these, combined with continued central bank support, point to an ongoing improvement in the wholesale money markets.

However, the focus of investors' attention is moving to the negative impact of the credit crunch on real economic activity. With such a high degree of uncertainty concerning the prospects for real economic activity both at home and abroad, investors are likely to remain nervous about the near-term prospects for equity markets.