Out of the frying pan, into the fire

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By Shaun le Roux

How the seemingly endless summer became the perfect storm

Before subprime exposed the first cracks in the pyramid scheme that once was first world investment banking, it felt like financial nirvana would be with us forever. Right now, the first half of last year feels like a long time ago, but that was when the world started changing – for keeps.

Back then, the world was growing at a rapid pace, all its engine cylinders were firing at the same time and no end was in sight. Inflation, the usual party destroyer, was hardly to be seen. Those that were prepared to take the most risk were reaping the greatest reward in areas such as commodities and emerging markets and, of course, by re-packaging products such as mortgage-backed securities.

Ben Bernanke, Fed Chairman since February 2006, presided over the later stage of the 2004 to 2006 rate cycle, during which the Fed Funds Target Rate (akin to our Repo Rate) was hiked from 1% to just over 5%. These hikes proved to be the straw that broke the camel’s back in the long standing bull market in US housing. Mortgage delinquencies first began to appear in late 2006 amongst freshly recruited subprime homeowners and the knock-on from the resultant write-downs caused the initial shock waves in financial markets. The de-leveraging of financial assets and freezing of credit that followed has snowballed into the crisis that we read about every day.

For a while the fall-out from the crisis in credit markets was restricted to the Financial sector. For almost a year up until mid-2008 the markets toyed with the concept of a de-coupling of the East from the West. Inflation then became a widespread concern as commodity prices exploded upwards with oil and food leading the charge. However, once the turmoil in financial markets took hold, the inflation scare proved to be somewhat of a red herring after commodity prices collapsed.

Eventually markets cottoned onto the gravity of the situation on Wall Street. Over-geared financial institutions around the world were struggling to find anybody willing to buy their assets or lend them money. The collapse in US house prices also started to show up in the real economy via declining consumer spending and rising unemployment. The slowdown was underway and recession was no longer a chapter in the textbook. Other leveraged Western economies were soon singing off the same hymn sheet and the powerhouses of the East which had become complacently used to exporting ever more goods to the West suddenly found themselves without their usual buyers for their goods.

The move out of the frying pan into the fire – from a financial crisis to a real economy crisis – is what has caused the global market meltdown of recent months. And the perfect storm was upon us.

The intensity and speed of the market crash that has followed can be attributed to two factors: forced selling and uncertainty. Capital-strapped financial institutions have been forced to sell assets to shore up their balance sheets. Other than the sovereign wealth funds, initially, and monetary authorities and governments, more recently, there have been no buyers. The lack of appetite for risky assets, such as equities and commercial paper, is largely down to the fact that the extent and duration of the perfect storm is impossible to quantify. What we do know is that there is an impending economic downturn and that the financial system is in a fragile state.

Markets do not deal well with uncertainty. Buyers prefer the sanctity of cash until the risky asset can be priced with any kind of certainty and, as they always do, panicky individual investors continue to take fright, sell and run to cash.

The result is a lot of risky assets priced for a very bad outcome.

It goes without saying that the best bargains are to be acquired when markets are panicking. We have no idea when the storm will blow over but take a lot of comfort from recent collaborative efforts from global authorities to shore up the financial system. In many cases we simply cannot see the calamity that is priced into many shares on the JSE. The move in the rand last week is a clear indicator of the lack of rationality of markets at present.

We continue to advocate that investors should focus less on the headlines and more on the valuations. In 2007 Alphen warned that valuations were rich and that expectations should be toned down. In our opinion, cash should have been raised then, when markets were expensive, and should be being put to work in cheap markets such as these right now.

The good news is that at current levels we don’t have to look far as to where the next bull market will come from.

Source: Shaun le Roux, Alphen Asset Management, October 21, 2008.

 

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