The US Federal Reserve’s rescue of investment bank Bear Stearns in March will go down as a seminal event in financial history. The ‘rescue’ consisted of a $30 billion non-recourse loan made to JP Morgan, to facilitate the acquisition of Bear. In effect, the Fed (read taxpayers) subsidised the acquisition.
This sent a signal to Wall Street and to investors that in today’s globalised world, financial institutions are too big to fail. The risk of a financial domino effect from a major financial bankruptcy is just too large to contemplate. So, investors ask, why price in risk when you know an institution is too big to fail?
This attitude has seen a sharp turnaround in global equity indices. The Bear Stearns event signalled a low point for the markets, as shown in the chart below. Assisted by huge injections of liquidity by global central banks (or, more accurately, the swapping of illiquid and suspect mortgage assets for liquid government securities) markets have moved relentlessly higher.
With the post Bear Stearns rally fading, it’s time to dust off the crystal ball and see what lies ahead. (Disclaimer: despite our best efforts, the Fat Prophets crystal ball remains perennially dusty).
The end of the credit crunch?
One of the most common refrains of the past few months is that the credit crunch is over, or that the worst is behind us. While this may be true, such pithy comments ignore the unique situation we are in. Our view is that the credit crisis is not over, but this does not mean the equity market will move to new lows in the months ahead.
Let us explain.
As we have written about previously, the global credit market is contracting, or put another way, deleveraging. This process has major ramifications for economic growth, which is why we think that the US economic recession/slowdown will be more prolonged than many people currently believe.
The deleveraging process involves banks taking assets back onto its balance sheet. Previously, banks would shift assets into off-balance sheet vehicles, known as ‘Structured Investment Vehicles’ or SIVs. The buyers of such assets ranged from leveraged hedge funds to money market investors searching for higher yield than traditional money market products.
Such activities allowed banks to recycle their capital (bank capital is necessary to support loan growth) and make fresh loans. These were the halcyon days for the global financial community.
But now, with an absence of investors in SIVs, assets are slowly moving back onto bank’s balance sheets. Along with all the writedowns associated with poor sub-prime lending practices, this leads to less credit being available to fund economic expansion.
So in our view, the credit crunch that began in August last year is now beginning to have an effect on real economic activity. Such a cyclical slowdown is not such a bad thing. However, this slowdown threatens to kick off a new round of credit market turmoil.
In short, as the global economy slows, credit market concerns could soon zero in on the corporate debt market and by implication the credit default swap (CDS) market. The CDS market is a huge derivative market that allows owners of corporate debt to hedge against potential default on that debt.
By itself, the CDS market, which effectively provides insurance against corporate debt default, is a good thing. The problem as we see it is that the market has grown so large, that no one really knows where the risk is concentrated. It’s all well and good to have insurance, but if your insurer can’t pay the claim...
We hope our crystal ball is particularly dusty on this point. We certainly don’t mean to sound alarmist, but in our view the deleveraging process and the effect on economic growth is one of the reasons why we continue to remain cautious on the financial sector.
Impact on Australia
In Australia, the global credit contraction may not have buffeted balance sheets to the same extent as it has in the US and Europe, but higher interest rates are leading to weaker credit growth. While credit may have grown at an annual rate of 14.1%, the majority of the strength was delivered in 2007. In the three months to April credit growth has slowed sharply, increasing by a total of just 1.8%. This should have an impact on bank profitability in the period ahead.
As illustrated in the chart above, the rally in the financials has stalled and over the past few weeks the sector has come under renewed selling pressure. We continue to recommend avoiding the banks. While a great buying opportunity may be approaching, we believe investors can afford to sit on the sidelines for some time to come.
The consumer discretionary sector (including retail and media stocks, sectors we have commented on in recent months) is another area we continue to avoid. The chart below shows the sector has broken down to new lows, which suggest there is no recovery in sight. Once again, there will be great buying opportunities to emerge from the sell-off but these will take time to emerge.
Gold
This brings us to the outlook for gold. Because gold is a currency, we view its prospects through the lens of the financial system. And here’s why we’re still bullish on gold:
Credit market deleveraging is a deflationary force. With the consumer based societies of the west deeply indebted, deflation will be avoided at all costs (deflation increases the real value of debt, inflation decreases it). We are seeing this already with the Fed, the European Central Bank and the Bank of England all swapping liquid government treasuries for illiquid mortgage debt.
We believe this process has only just begun. For example, the Federal Reserve’s stock of treasuries has declined by $300 billion over the past few weeks, to just under $500 billion. What happens when the Fed has no treasuries left? As the lender of last resort, it can just buy more from the Treasury.
This is an inflationary policy, but is seen as the lesser of two evils. It is not surprising to see therefore, a sharp rise in oil and food etc as the increased liquidity in the financial system moves into commodities.
So why isn’t gold rising? Is our call on higher gold prices wrong? We cannot say for sure why gold is not increasing in this environment. Perhaps gold’s rise from around US$750 an ounce in August last year to over US$1,000 discounted the inflation we are now seeing. The current correction in the gold market therefore needs to be viewed in the context of the solid performance of the prior six months.
As the chart below illustrates, there is also a seasonal element to consider in relation to gold. The northern hemisphere summer is normally a quiet period for the gold market. The shaded areas denote the northern summer months over the past three years, which are characterised by corrective activity or sideways movement.
Following each of these periods, over the past few years the gold price has rallied strongly. We retain our conviction that after a period of consolidation, gold will once again move to new highs.
Investors who are bearish on gold need to consider the implications of a lower gold price. A falling gold price indicates the US dollar and a range of fiat currencies will strengthen. This in turn suggests greater purchasing power for fiat currencies, or, put another way, a deflationary environment whereby the price of goods falls in terms of fiat currencies.
If anyone, anywhere, can tell us their paycheck is buying more than what it used to, or thinks that it will in the future, we’d love to hear from you. Throughout history, inflation has been the ‘answer’ to economic ills, as officials try to print their way to prosperity. We can’t see why this episode will be any different.
So, in this environment, even though we may experience another credit market scare, we believe equity markets may discount an inflationary response. In such a scenario, the lows experienced earlier in the year should hold.
Unfortunately, our gold stocks have not performed well despite this inflationary environment. Or perhaps its because of the inflationary environment. Given the energy intensiveness of gold mining operations, rising oil prices (far outstripping the gold price rise) continue to hold gold stocks back. We’ll address the issue of gold versus gold stocks in the weeks ahead.
In the meantime, our strategy remains the same: maintain exposure to real assets (commodities, gold etc) while avoiding the financials and consumer related sectors.