Early this week, Sir John Gieve, Deputy Governor of the Bank of England, when speaking at an industry conference said, “The woes of the financial sector were likely to squeeze the economy even more powerfully than had been expected, while the other economic threat – from inflation – appeared to be subsiding.” He also said, when speaking to the Family Offices Leadership Summit “The biggest risk to the financial sector is also the biggest downside risk to the economy; namely that damage to bank balance sheets would lead to tighter credit conditions, lower asset prices, lower consumption in investment and to a severe feedback loop into more losses for banks and so on down a spiral.” Pretty heavy stuff!
Having opened with Sir John’s quote and because what key people say is often illuminating and informative, but then, at certain times, totally deceptive, we will make them a theme of this issue – quotations; some historic, some current – and consider the inferences that can be garnered from those words to better understand, not just what’s going on now but, more importantly, what is coming towards us through the mist.
We will begin at home. On 14th May 2004, in issue number 468, of our newsletter, then called “Onassis”, we wrote: “The period since 2000 has been a real-life experiment: the laboratory – the global economy, the head scientist – Alan Greenspan and the laboratory mice – the American consumers.
“Using historical models, such as the 1930s in the US and the 1990s in Japan, the Fed concluded that those economic nightmares could have been avoided by appropriate monetary and fiscal policies. As from 2000 onwards, economic conditions rapidly deteriorated, so the Fed’s easing became aggressive, thirteen rate cuts in all ending with an emergency rate of 1%, where it still rests. Negative real interest rates have been the order of the day which, in turn, has created a huge debt bubble.
“The excesses of this process are extraordinary. New car loans over eight years being just one example. Interest rates at emergency levels have also triggered a laxity in lending criteria, typified by a recent statement by Reuben Ybarra, President of Chicagoland Home Mortgage, who said “There are an incredible number of loans that get approved now that would have been way out of bounds a few years ago”.”
As everybody now realises, Alan Greenspan’s Fed policies, known colloquially then as the “Greenspan put”, created today’s nightmare scenario and could still tip their banking system down the toilet and transform the US economy into the arctic conditions of a deep recession of historic proportions.
Even earlier in 2002, Alan Greenspan was held in such high esteem that the Queen knighted him; bizarrely, Gordon Brown, then Chancellor of the Exchequer, insisted that the citation should say “For promoting economic stability”.
In April 2005, Mr Greenspan congratulated himself by saying “… marginal applicants would simply have been denied credit; lenders are now able to quite efficiently judge the risk posed by individual applicants and to price risk appropriately. These improvements have led to rapid growth in subprime lending.” Very recently, as if he were no more than an informed observer who played no part in the drama, he observed what is going on as a “once in a hundred years’ event”.
There is little doubt in our minds that Hank Paulson and Ben Bernanke will have their way with Congress and, in due course, after much posturing by certain members, the $700 billion bail-out plan for banks will be sanctioned, otherwise Warren Buffett would not have invested $5 billion in Goldman Sachs, albeit on fantastic terms, perpetual preference shares yielding a fixed 10% per annum which Goldman Sachs can only buy back if they are willing to pay a 10% premium. In addition, a warrant to buy $5 billion common stock at an “in-the-money” price.
At the taxpayers’ expense, the American banking system is going to be saved, however, not without more casualties. [Since writing this, Washington Mutual has been seized by the American government; it is America’s biggest bank failure ever!] Many more American banks will disappear. When asked on this point, the Chief Executive of Bank of America, Ken Lewis, said that, in his opinion, only half of the 8,500 US banks will survive.
Even George Bush, President of “the glass is always half full” nation, warns of a “painful recession”. It truly must be bad, if he is now admitting the glass is empty.
According to David Rosenberg, North American Economist at Merrill Lynch, “After the Resolution Trust Corporation was established in 1989 [on which Paulson’s plan was based], it took a year for the stock market to bottom and three years for the housing market to bottom.”
We ask ourselves these simple questions:
1. Have property markets bottomed out? No. Mortgages in August for house purchase and remortgages were 2/3rd of the level of a year ago. “The history of this is serious, there has never been such a rapid decline in mortgage applications” said Seema Shah, Property Economist at Capital Economics.
One in ten US mortgage is delinquent or in foreclosure and house prices are still falling.
2. Will unemployment rise? Yes. UK unemployment benefit claims rose in August at the fastest rate for 16 years, the seventh consecutive monthly rise.
John Philpott, Chief Economist at Chartered Institute of Personnel and Development,
“The economy is increasingly likely to experience an avalanche of job losses in coming months.”
3. Will credit expand? No.
4. Will consumer spending rise? No.
5. Will corporate earnings rise? In the main, no. Credit markets continue to contract, the housing market continues to falter and consumers continue to cut back. This is a major on-going process which will inevitably damage the outlook for corporate earnings. The consequences of a credit contraction of this magnitude are to impact adversely on corporate earnings and also materially affect the optimism of investors who, looking forward, will not be prepared to pay the same multiple. Primary bear markets don’t end until P/E ratios on current earnings are in single figures. We expect the stock market to move much lower, even if the American banking system is saved.
6. Will banks endeavour to grow their business by increasing their lending? No. Because first, they need to increase capital or reduce their loan book – probably both.
Against that background, it’s just not possible to have a positive view about asset markets.
Below are five-yearly charts for the FTSE 100, the S&P 500 and the Euro Stoxx 50. These are the indices that are used in structuring the SocGen Bear Accelerator Note. They clearly indicate that primary bear markets still prevail.
We also publish the up-to-date chart for the SocGen Bear Accelerator Note. If we are right that the bear markets are unfinished business, then this investment will provide a very considerable benefit to portfolios.
We find it implausible that, given the noxious conditions, irrespective of whether or not Paulson’s deal is approved by Congress, the bear markets are over. A leading light in the private equity business, Jon Moulton, founder of Alchemy Partners, recently said to Richard Tyler of the Daily Telegraph, that we are in a serious recession and it will be the worst we have had for a very long time. Surely, no-one would disagree with him.
There is no way in which businesses and consumers can thrive nor asset markets prosper in these conditions.
A potential China investment opportunity
Since October last year, the Chinese stock market has been bashed up very badly, having lost more than half its value. We have, week-by-week, patiently watched events because we know that this will develop into a significant opportunity. It’s only a matter of time before the Chinese stock market recovers and eventually makes new highs. China continues to economically outrun the rest of the world.
China’s Ministry of Finance have announced the removal of stamp duty on share purchases. Their Sovereign Wealth Fund plans to buy shares of their leading banks. The top regulator has approved a buy-back of shares of listed state owned companies by the parent company. All of that was preceded by a recent interest rate cut – the first for six years.
Once we have decided to make the initial investment, probably in the iShares FTSE/Xinhua China 25 Index ETF (NYSE:FXI) (chart below), if we are proved to be right, we will then look to build on it.
• This article was written by John Robson & Andrew Selsby at Full Circle Asset Management, as published in the threesixty Newsletter