Pig-Sticking A Panzer

A year ago the Investment Review was headed ‘Ringing the Bell’ – a flamboyant attempt to call the top which, with hindsight, I’d never try again.  True, the top came some five months later (we assume) – not far off judged by the timescale of market cycles, and the proximate cause was exactly – indeed alarmingly – the one offered as its nemesis.  Why, then, was it a mistake?  The answer was that it wholly underestimated the strength in the beast of the bullmarket.  In the last six months, the asset–backed securities sector, worth some $5 trillion, has completely gridlocked.  The US housing market is in freefall, and the European looks as though it is following.  Commercial property is in stasis: the fifth biggest UK mortgage bank is beached, the European Central Bank has made available an extra $280 billion . . . yet the world equity market is down around only 5% from its peak.  We posed as the pig–sticker and encountered not a pig, but a panzer, which has absorbed a fearful battering of bad news pretty much unscathed.

Never have market views been more polarised.  The optimists see the Federal Reserve admirably responsive to the rolling financial crisis, and are encouraged that the European Central Bank has been flexible and decisive in its dealings.  Economic growth has remained robust – tellingly, with the Far East coming in stronger than ever.  The bulls hope that a problem contained in the West, with a brave new world in the East, is one with which the markets can live, particularly now that the credit crunch is no surprise – the thing the markets most fear and hate.  ‘Fully discounted’ is the sister–in–law to ‘decoupling’ in their dictionary.

For the last 25 years, the betting has always favoured those who have underestimated the true nature of a crisis.  Over that period there have been many things which looked overwhelmingly frightening – balance of payment deficits, the derivatives timebomb, the debt overhang – but the key to money making has been to ignore them.  Those who had a true understanding of each of these dangers regularly made the mistake of disembarking from this generational gravy–train of asset appreciation.  Best, therefore, not to enquire too closely of the danger, lest it cause a grievous loss of nerve.  It is an inversion of the fairytale of the boy who shouts ‘wolf!’: this one keeps his eyes shut and never shouts wolf, even when it is biting his shoulderblade.

This time, the credit problem is el Gordo – the fat one.  A quick recap.  An enormous amount of money has been borrowed, some of it by people who were never going to be able to pay it back, and a lot more of it by people who needed the value of the assets to go up if they were to be able to pay it back.  Although that first category has duly blown up, and both the quantum and the whereabouts are unknown, it does not look to represent a systemic banking risk – some hundreds of billions of dollars to be absorbed by a US financial system where the banks have a net worth of around $1.3 trillion.  The hits to the big financial institutions have inevitably generated both uncertainty and a marked reluctance by the banks to make new loans, but the central authorities are doing everything they can to alleviate these pressures.  The optimists pin their hope – almost an assumption – that this will succeed.

We think that this optimism is, by and large, soundly based, and we have no particular argument with those who think this battle will be won.  Nevertheless, this victory will not be enough to avoid a severe credit rationing, and the consequent economic effects which flow from this.  The credit rationing will have an unfavourable effect on asset values – and that will compromise the second, much larger, category of borrowing.

To assess the depth of the credit problem, one must understand the structural changes which have taken place in the financial world.  Over the last 10 years there has been a revolution in lending.  By the summer of 2007, the majority of it had been done outside the banks, taking the form not of loans held on bank balance sheets, but of investments processed by those banks, and sold in the form of securitised debt to long term investors.  Although these investors are well able to take the losses which are only now becoming apparent, they are by nature conservative, attracted to these asset–backed securities because of their security, first of cashflow and, by extension, the capital value.  Many of these investments are now unsellable, and some are clearly worthless.

Our view, based as much on common sense as high economic theory, is that this ‘non–bank’ lending is impaired; the conservative investors have learnt their lesson – the lesson being that danger can lurk in seemingly safe opportunities.  The good news is that the dislocation will remain largely where it falls.  Those conservative investors will suck their teeth and take the pain – a myriad of portfolios, some government–backed, some representing pensions, some insurance money, some fund of funds: each will be worth a few percentage points less.  If there are large losses to absorb, it could not happen to a segment of the financial community better able to wear it.  The bad news is that the dislocation will have a much greater effect on the availability of credit in the future.  Non–bank loan growth was running at nearly $3 trillion annualised; it isn’t any longer.  Unless the banks can take up the running, the economic consequences of sharply reduced credit availability will be apparent.  Alas, the banks are struggling to keep even existing commitments in place.  Even if, as we think, they do remain open for business, their capacity to lend will be much reduced, owing to the failed investments which they will have had to take back on to their own balance sheet.  The will to expand the loan book will be more than correspondingly reduced.

At the end of the year, a surprising amount of this has not yet been reflected in a reduction in consumer demand.  Liquidity in vehicles which take consumer credit assets has dried up, issuance has stopped, but retail sales have held up remarkably well.  One of the main reasons for this has been that credit card spending has gone sharply up, with double–digit growth in what is essentially the most expensive way of borrowing money short of the pawnbroker.  Consumers in the United States seem to have kept their expenditures rolling along for another few months, but at the cost of borrowings at triple the rate available in the good times.  Whom the gods wish to destroy, they first make mad.

These developments – or, more precisely, the lack of them – have meant that our investment positions remain pretty much undisturbed from three months ago.  The long awaited weakness of Sterling has transformed the short–dated Swiss and Norwegian government bonds from little chalices of nausea into springtime celandines.  The short–dated gilts are performing well, as there is an increasing realisation that the economic outlook cannot support interest rates at their current level.  We remain of the opinion that only a sharp fall in the stock markets stands between interest rates at their current level and levels no more than half where they are today.  We remain reluctant to grasp the nettle of purchasing index–linked bonds, despite the fact that we believe that they will be a formidably good investment over the next three years as governments compromise their currencies in order to palliate the effects of financial dislocation.  There will be, we hope, time enough to do this.  Meanwhile, we have substantial investments in both gold bullion and gold shares, which have exactly the right characteristics in a world where the major currencies are being compromised in coordinated fashion.  Our view on equities is fairly conventional at the moment – favouring big capitalisations over smaller ones, and, less consensually, to favour nifty–fifty ideas in America at the expense of Europe.  Food inflation is now a well–worn investment theme, and we have moved from the primary producers into the food processing companies, on the basis that commodity inflation is like a goat passing through a boa constrictor, and we think it is time to move away from the jaws towards the middle part of the snake.

We hope you had a happy Christmas, and we will endeavour to produce for you a prosperous New Year!

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Investment Review October 2007