Three weeks ago, if you’d asked anyone in the City if they expected the market to crash at any point in 2007, they’d have said no. They’d have pointed at the seemingly endless cheap credit on the market, at the buying power of private-equity giants, the fine state of the global economy and the cheap(ish) valuations of the world’s big markets. The FTSE 100 is trading on an average p/e of only 12 times, someone said to me last month – it wouldn’t make sense for it to fall. If pushed to think about the risks inherent in the system, most of them would have said that it didn’t matter: risk, the story went, is now so widely spread around the world that no one can get too badly hurt whatever goes wrong. Some might have believed this, but most City people parroting the bull case were lying through their teeth. They knew it was nonsense.
Remember the dotcom bubble? There is much muttering these days about how foolish everyone in the City was and how they should have known everything was overvalued and bound to crash, as it finally did. But the truth is they did know. In fact, by the time the bubble burst, they’d known for years. The problem was the same as it has been for the last few years: they just didn’t know when it would fully emerge. Meanwhile, they were being paid to buy into the mania and make money. Look back to our recent roundtable discussions and you’ll see what I mean: all the participants said they were bullish; at the same time, they all agreed the odds of a ‘credit event’ were high, but that they had no idea when it would come. When it did, all bets would be off. But until it did? Buy, buy, buy!
I’m not going to go into the details of how and why this credit event has finally happened, as we’ve written about the history of it all several times before. As far back as September of last year we were asking if CDOs could “topple the financial markets” – go to our credit crunch section to access this and our other best articles on the subject. Instead, here we will look at exactly how deep the crisis will go and what might happen next. It doesn’t help that investors still can’t face up to reality. European Central Bank president Jean Paul Trichet is still insisting that market conditions are returning to normal, and most brokers are saying that this is a brilliant buying opportunity. At worst, they say there may be an “uncomfortable period” (to quote Richard Scott from iimia), after which “the bull market is likely to recommence”. This is unlikely. Some experts may really think that we should be buying on the dips, but give an old hand a drink and he’ll tell you to sell on the bounces instead: the truth is that the risks are very much on the downside. Sure, there’s always something to buy or to think about buying, but a full-scale opportunity? We don’t think so. Here’s why.
1. No one knows where the losses are
The financial industry is fabulous at making things sound complicated and they’ve outdone themselves with the subprime crisis. But the essence of the problem is simple. Asked to explain it in under two minutes on Radio 4’s Today programme earlier this week, I explained that it’s all a bit like making sausages. You’re a butcher. You’ve got a bit of pork you think might be bad. You could chuck it out or eat it yourself, hence keeping the potential pain in the family. But you don’t. You chuck it in the sausage machine and sell the sausages on. The result? If it really was bad no one will be hospitalised,just a lot of people will get a bit ill. Substitute subprime mortgage – or indeed any other bit of debt you don’t want to keep – for pork, and you get the picture. The way that dodgy debt has been chopped up and sold through the market means the trouble has spread everywhere: too many people are getting too ill.
The complication is that the crisis isn’t really about the actual subprime mortgages, of which there aren’t very many. As Anthony Currie points out on Breakingviews, the sum total of problem bonds is about $25bn. Instead, it’s about the derivatives market based on them. This has allowed issuers to create synthetic mortgage-related bonds. As these aren’t real, they’ve been able to create as many as they like. We just don’t know how many – perhaps $1trn worth, perhaps $3trn – and we don’t know who holds them. All we know is that now the defaults have started, they aren’t worth as much as they once were; and that all those losses are still out there.
It is this, says Currie, that has transformed a “regional problem into a global nightmare”. Conventional thinkers, says CLSA’s Christopher Wood – who is far from one himself – have long been fond of saying that the chopping up and selling on of debt (securitisation) is a good thing. It spreads risks and then losses across the system rather than containing them on just one balance sheet. But “the truth is more sinister. For the grim analogy that most resembles securitisation run amok is a body ravaged by cancer. Just because it is not possible to see the problem does not mean it does not exist.” It does. The central banks have eased the pain of the whole thing with their injections of cash into the market. All this means, by the way, is that after seeing the credit system was seizing up – financial institutions stopped lending each other money for fear of not getting it back – they stepped in to lend money to those who needed it. But the central bankers can’t actually cure the disease itself.
2. A lot of hedge funds are in a lot of trouble
United Capital Markets founder John Devaney has had to put his 143-foot yacht on the market to cover losses. He won’t be the last manager to have to flog off his credit-bubble baubles. Hedge fund managers, much as they like to pretend they are all extra-clever contrarian mavericks, are nothing of the sort. Instead, many adopt similar strategies – usually driven by the same sort of computer models and momentum charts. This is fine when things are going well, but terrible when the assets they are investing in start to wobble: then all funds melt down at once.
When margin calls go up (ie, the banks that lend money to hedge funds – their prime brokers – ask them to cut their borrowing levels), or when investors demand their money back, the funds have to sell assets. That pushes the price of those assets down further and makes everyone more nervous about all funds. So more people ask for their money back and margin calls go up further. This is why the Goldman Alpha fund lost 27% last week and why the bank has had to inject $2bn of its own money into the fund and bribe outsiders in with promises of low fees. It is also why Illinois-based Sentinel Management is trying to freeze withdrawals from its funds. And why AQR, a huge computer-trading-based hedge fund running $38bn (well, once running $38bn) is reported to have been forced to raise $1bn to bail out one of its funds too. None of them will be the last to have to own up to problems like this, or to attempt to freeze withdrawals from their funds. Looking for a cheap yacht? Give it a few more weeks and you might be in luck.
3. The banks are going to suffer
For years now, the world’s big banks have made a killing out of securitising loans (packaging them, slicing them up and selling them on). They’ve been able to front-load revenues (they effectively get the loan paid back right away) and to make more loans than they otherwise would have. This source of easy money is bound to start drying up. At the same time, their investment-banking divisions will suffer if the mergers and acquisitions boom falters; their equity trading businesses will suffer if the market falls; and they could well lose money on the loans they have made to hedge funds. And, of course, most are probably holding some bad credit instruments in their own portfolios. Note that UBS, still smarting from the subprime-driven blow-up of its internal hedge fund Dillon Read Capital Management, warned the market this week that the second half would be “very weak” for investment banking.
4. Credit will tighten for everyone
The leveraged buyout market (where private-equity firms borrow lots of money to buy companies) has been working much like the mortgage market. Banks lend the money out, but then instead of keeping the debt on their own balance sheets, they sell it on and go looking for a new deal. But when the crisis hit a few weeks ago they started to find there was no market for the old debt. This has to make them reluctant to issue more. That’s going to hit private equity and it may also make it harder for ordinary businesses to get their hands on the credit they want.
It may also affect the equity market: the expectation that private equity would be willing and able to buy anything and everything has long been propping up the equity markets. But tighter credit is moving even closer to home than this. The UK’s subprime lenders have to raise the money they lend out in the wholesale market just like everyone else. The result? They’re tightening up too. Infinity Mortgages, DB Mortgages and Unity Homeloans have all withdrawn subprime products in the last few days and Merrill Lynch subsidiary Mortgages plc has confirmed it will be ‘re-pricing’ its subprime range. My guess is that the days of being able to tell a broker that you want an interest-only mortgage worth six times your salary without him laughing in your face are all but gone. This won’t be good for the housing market and, by extension, the UK economy.
5. The global economy isn’t all that strong
The bulls are fond of pointing out that the US economy looks fine, which means, they say, that the fundamentals of the market are fine. But are they? The financial sector makes up about 30% of S&P 500 profits and we can guess that it isn’t going to have much of a second half. We can say the same about anything else property related – construction, for example (existing home sales are down 12% on last year). But much worse, it’s starting to look like we can also say it about the main driver of the US economy (and for years of the global economy): consumption. US retail giants Wal-Mart – the best bellwether of the state of the US economy there is – and Home Depot have both said that the housing slump will hit their earnings. It is no secret, said Wal-Mart’s chief executive, that “many customers are running out of money towards the end of the month”.
Need more proof the US is in trouble? Then note this, says Damian Reece in The Daily Telegraph: “they are stealing food at Wal-Mart”. Economic barometers “don’t come much more blunt… than the correlation between hardship and theft”. In the UK things are better, but given the extent to which we too are dependent on financial services and housing for GDP growth, they may not be for long. And European growth is also faltering. No wonder a Goldman Sachs survey of confidence of global chief executives has come in at a five-year low. A lot of people in the market are claiming to see massive value (today’s most idiotic press release claims “when the going gets tough, the tough go shopping”), and maybe there is. But much of the analysis that supports this is based on the assumption that the global economy is strong. What if it isn’t?
6. What you can still safely buy
We do not hold with the view that recent events have created a fabulous buying opportunity across the board. But it is an opportunity to buy into a few sound long-term stories.
Commodities
In the short-term, the credit crunch is set to dent commodity prices as investors facing margin calls sell whatever they can. But the long-term picture is bright, with unprecedented demand from industrialising Asia’s 3.5 billion people underpinning a commodities supercycle that, history shows, should endure for at least another five years. Brazil, Russia, India and China will need 105% of last year’s copper output by 2015, according to Evy Hambro of the Blackrock World Mining Fund.
On the supply side, a legacy of underinvestment, along with resource nationalism and equipment and staff shortages, is hampering supply growth. The “inelastic supply meets rising demand” theme, as David Fuller of Fullermoney puts it, also applies to oil. Here, the lack of a major discovery in the past 30 years and surging Asian demand – expected to double by 2030 – presages plenty of new record peaks ahead. It’s a similar story in agricultural commodities, where population growth, the trend towards biofuels, and demand for more protein in developing countries is spurring demand. Meanwhile, stocks of many agricultural raw materials are at record lows. No wonder Hugh Hendry of Eclectica thinks agriculture is “the next copper”. London-listed ETFs allow investors to track individual softs as well as the Dow Jones Agricultural Commodities Index (AIGA).
Cheap as blue chips
Ultimately, the companies that benefited least from the credit boom should prove resilient. Largely because they’ve been ignored in the recent takeover frenzy, some of the biggest and best dividend payers are historically cheap. Commodity stocks look the best bets here. Oil plays BP (BP., 540p) and Shell (RDSB, £18.44) are on 2007 p/es of 10.5 and 9.2 and yield 3.6% and 4.8% respectively. Mining giant Xstrata (XTA, 2,688p) is on a 2007 p/e of just 8.5, while Rio Tinto’s (RIO, 3,159p) “terrific range of natural resources”, says Fuller, is available for just 10.1 times expected 2007 earnings. BHP Billiton (BLT, 1,293p), on a p/e of 10.4, is also worth a look.
Gold
This safe haven and store of wealth has barely moved amid the market turmoil of the past month. But its inertia seems unlikely to last for long. Gold has been sold off with other assets as investors attempt to shore up their positions because “it is the most liquid asset bar none… investors know they can always find buyers for gold”, says Douglas Gnazzo on Financialsense.com. And history shows that as a liquidity crisis progresses, the yellow metal’s safe-haven properties come to the fore, he says. There’s the credit crisis and the threat of a nasty US downturn induced by the collapsing housing market, while on the fundamentals front, supply is falling for the third year in four and the impending wedding season in India is set to bolster demand. The prospect of central banks easing as conditions worsen may fuel worries over inflation, while James Moore of Thebulliondesk.com notes that jitters over US mortgages look likely to prompt investors to trim their dollar exposure. Sean Boyd of Agnico-Eagle Mines sees prices hitting $850, the 1980 record, in eighteen months. All this should also be good for silver. There are two London-listed silver ETFs, ETFS Silver (SLVR) and ETFS Physical Silver (PHAG); gold ETFs include Lyxor Gold Bullion Securities (GBS).
Emerging Asia: keep an eye on India
Emerging markets always hit trouble in times of risk aversion, so it’s no wonder Asian stocks have fallen by around 10% from recent record peaks. The long-term story remains compelling, however, with balance sheets strong and domestic demand growing. Now may not be the time to buy, but, says Christopher Wood of CLSA, a full-scale credit blow-up could wipe over a third off regional stocks, heralding a “massive buying opportunity”.