Barron’s recently published an article by Randall W Forsythe, headlined “Pouring over the notion of liquidity”. An important point that he makes, which has often been reported in this letter, is that commercial banks, under the jurisdiction of Central Banks, no longer control credit. When they did, it was possible to measure the amount of credit by looking at the liability side of the banking system’s balance sheet. Now credit is mostly created entirely outside of the banking system by the issue of corporate bonds plus a mind-blowing array of derivatives that Randall W Forsythe says “grow like mushrooms after a spring rain”!
Credit markets continue to expand
He says that the yen carry trade alone could amount to anything from $20 billion, the low side of Morgan Stanley’s Chief Currency Economist, Stephen Jen’s estimate, all the way up to $1 trillion which is where Jesper Koll, Merrill Lynch’s Japan Economist puts the figure – whatever the number is, it is truly enormous! This vast availability of credit across the markets, making size no impediment for any bid for any company, will continue so long as the perception of risk is low.
Financial institutions, he also explains, very carefully monitor the risk they are taking on, using a technique called “value at risk” (VAR). This process attempts to quantify the size of risk they are subject to and here it gets quite interesting because the higher the market’s volatility, the greater the VAR; so the future behaviour of the VIX index is a paramount indicator. Because it’s one of our horses, we will comment upon that separately later. As we have said all along, monitoring the VIX is key to identifying credit contraction in its early stages.
Commercial property market performing badly
According to the Wall Street Journal, UK Real Estate Investment Trusts (REITs), which were introduced in January, are the worst performers in the world with negative returns this year, causing leading analysts to call the end of the four-year boom in British commercial property. The Bank of England’s ongoing interest rate policy is clearly having a deflationary impact upon UK commercial property. Traditionally, REITs trade at a premium to net asset value, reflecting the vehicle’s tax efficient structure. The UK is the only country where the REIT market is trading at a discount to the net value of the underlying property asset.
The UK stock market real estate sector (see chart) is developing a significant top, its high was registered in December just prior to the introduction of REITs. If this negative price action continues, property funds may be put under pressure because of their innate illiquidity. If investors start redeeming, a situation might then develop forcing property funds to sell property in order to meet the needs of departing investors. Such selling might well cause a significant fall in the value of property funds. At some point, illiquid property funds will represent a real problem for investors. Credit contraction will therefore hit these types of investments hard.
HSBC, who were hit badly by the sub-prime mortgage market in the US, clearly have a view that the property market topping out, having just announced the sale of their headquarters in London, the first ever £1 billion property deal. They are also in the process of selling more of their UK property assets.
UK housing market under threat from rising rates
The Bank of England has raised interest rates yet again. They are determined to put a lid on inflation which, in our view, they can only achieve by putting a lid on asset inflation. House prices continue to rise although, in March, according to the British Bankers’ Association, mortgage applications were down 12% to 75,098 compared to March 2006. For the first quarter 2007 versus the first quarter 2006, insolvencies were up 24% to 30,075 – the first time ever the number has been above 30,000 for any quarter.
Last week’s rate increase will make things worse for UK over-borrowed house owners.
Chinese stock market looks overheated
On Wednesday 9th May, the Financial Times reported that the total trading on the Chinese stock market was greater than the rest of Asia, including Japan, and also greater than the London market. It was 21% above the previous record set at the end of April. Going back six months, it was only averaging $5 billion per day, yesterday it totalled $49 billion. The stock market is up 300% in less than two years; investors, ignoring continued warnings from the Bank of China, are pouring money into the market which is now priced at 50-times trailing earnings. It could well be that whilst we carefully watch the US, the overdue correction we await might be led by China. In February, China frightened the market by falling 11% in one day, only then to return to exponential growth. Well known investment analyst, David Fuller, about exponential growth, says that acceleration always leads to an ending.
What the key market indicators are telling us?
The white horse – false peace – The Volatility Index (VIX)
The published chart covering the recent twelve months, picks up the VIX rise in June 2006 and the one in February/March 2007. On examining the chart, it can be seen that when the VIX topped out in June 2006, it then fell back to the long-term lows at about 10. This time round, so far, that hasn’t happened. Following the March top, the action is a pull-back rather than a return to weakness and so the levels we have identified previously at 11.2 and 16 remain important. Whilst it remains above 11.2 the risk of the VIX returning to strength is strong and the subsequent risk to liquidity is serious.
The red horse – war and destruction – The Philadelphia House Market Index
Robert Toll, CEO of US luxury house builder Toll Brothers has just sold $8.3 million of Toll Brothers’ shares at $27 a share. It previously traded as high as $65, his actions offer a sharp insight into his inside view of the future of the house building business.
Gary Shilling of Gary Shilling & Co., investment advisers and economic consultants, has estimated that there are two million excess homes in the US; if at the same time mortgage lending is becoming more restrictive, which it certainly is, then the reduction of that overhang will be very difficult. On the one hand mortgages for many potential buyers become less available and on the other hand, many other potential buyers will wait patiently for the market to go lower.
The black horse – famine and unfair trade – Dow Theory
The Dow Jones Industrial Average continues to rise almost every day although the Transport Index has stalled just above its February high. An examination of the up-to-date charts will see only a very modest confirmation of the strong Industrials by the Transports but so far no follow through.
In the absence of the Transports breaking out to the upside, Dow Theory, for the moment, adds a cautionary note.
The pale horse – sickness and death – The Inverted Yield Curve
The US three-month interest rate is still at 5.25% as is the Fed’s Fund rate, whilst the 30-year yield is at 4.84%. The inverted yield curve continues which has always indicated that something is seriously amiss in the economy. In the UK the yield curve also remains inverted.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/