The end of the world is nigh
Tim Price Before September, British portfolio managers had only ever seen a run on a bank on the cinema screen. It's a Wonderful Life shows how the Bailey Building and Loan is saved by the prayers of the local community. The collapse of Northern Rock suggests that modern finance doesn't quite work that way. Unfortunately for investors throughout the world, there is probably much worse to come.
For a solvent mortgage lender to require emergency government support on a huge scale suggests that all is not well in our financial markets. This understatement matches the gorgeously hubristic claim from 'Chuck' Prince of Citigroup, America's largest bank, in July, that 'as long as the music is playing, you've got to get up and dance. We're still dancing.' But by November Prince was gone, victim of a multi-billion-dollar write-down relating to losses in the mortgage market. Perhaps he now dances with Stan O'Neal of Merrill Lynch, America's biggest stockbroker, who also resigned in November after giant mortgage-related losses.
Countless institutions have been brought low, having invested in supposedly low-risk bonds cobbled together from mortgages on US property. Banks everywhere have managed to choke themselves on an alphabet soup of mortgage derivatives: CD0s, MBSs, CDSs, SIVs. For as long as US property prices rose, nobody bothered to look under the bonnet and see what was actually powering the enhanced returns available from repackaged sub-prime loans. It's now painfully clear that too many lenders threw too much money at too many high-risk borrowers. What is not clear is how great the exposures are (analysts at Deutsche Bank suggest sub-prime mortgage losses could total $400 billion worldwide, but nobody really knows), nor on whose balance sheets and portfolios they sit. As a result, banks no longer trust their counterparties enough to lend to each other: the financial system has broken down. Wounded banks will offer more stringent terms to borrowers, individual and corporate.
With easy money now gone, big takeovers that were previously possible thanks to a surplus of credit on attractive terms will dry up. That removes a key pillar that has underpinned equity market valuations. A highly regarded economist, Nouriel Roubini, recently wrote that he now sees `the risk of a severe and worsening liquidity and credit crunch leading to a generalised meltdown of the financial system of a severity and magnitude we have never observed before'.
The outlook darkens, if that's possible, because the US property bubble was never the most extreme. Between 1997 and 2007, according to the Case-Shiller national index, US house prices rose by 120 per cent. Over the same period, house prices in Spain rose by 189 per cent, in Britain by 211 per cent, and in Ireland by no less than 251 per cent. British commercial property prices have already started to soften. The US real estate slowdown is likely to go global. And house prices matter because consumers, particularly Americans, having lost the appetite for saving, have been treating their homes as ATM machines. Since consumer spending accounts for roughly 70 per cent of US GDP, weaker property prices have a direct impact on economic growth.
Faced with a slowdown, the answer for the US Federal Reserve seems obvious: cut interest rates. But the Fed also has a mandate to ensure price stability, and it currently has a rapidly weakening dollar to contend with, not to mention rising food, oil and commodity prices. So simply cutting rates runs the risk of sending the dollar into freefall.
One time-honoured market alarm bell is already ringing: gold. After two decades in the wilderness, the gold price has doubled over the last three years. As Redburn Partners analyst Paul Mylchreest says, the biggest credit bubble in modern history will either be purged in a deflationary recession, or inflated away through currency debasement. In either scenario, gold wins, and is `the "go to" asset along with basic commodities like food and energy'. Happily, it has never been easier to own gold: a number of cost-effective exchange-traded funds have been launched in recent months, allowing investors to own bullion without taking physical delivery.
Another 'safe haven' asset: the oftmisunderstood hedge fund, with a mandate to generate positive returns in all market environments. While classic hedge funds are only available to the truly well-heeled, the London Stock Exchange now offers retail investors access to so-called closed-end funds of hedge funds, a number of which (such as Dexion Absolute and Thames River Multi Hedge) have admirable track records.
The end of the financial world may not, of course, come to pass. But confidence in markets, once lost, takes a very long time to be regained. Investors will be well advised to reassess their commitment to equities and other risky assets, because the future promises to be unusually volatile.
Tim Price is director of investment at PFP Wealth Management.
Previous page
