Friday, 31 October 2008

Just a feeling? Don't bank on it

We have sensed it for a while but signs are multiplying that there is indeed a recession on the way, and it appears that the slowing of the economic growth rate is rapid. When I use such careful terms it is the consequence of the simple fact that reliable economic data releases often arrive only three months after the events, so in fact we still have only very little facts to judge the situation on.

We have received a slew of economic indicators from the US since the banking crisis broke in early September. Which is in fact quite remarkable since we are now only at the end of October. This is because US economic indicators to a higher degree than elsewhere in the world are based on what could best be characterised as opinion polls. Where many other countries have national statistical offices, tasked with collecting and treating economic data right from the sources, this is not the case in the US. Many US economic indicators are indeed based on interviews, aiming to recreate a sentiment. This is not entirely unreliable to the extent that sentiment often precedes decision making.

In the current situation, however, it makes judging the actual situation a good deal more difficult. We have been presented with 24/7 coverage of the banking crisis, in some instances it has even made its way into the sports pages (sic!). Obviously, that has made a great impression on many. When we then have that our own uncertainty a few weeks later is repackaged and presented as an economic fact, we become even more nervous.

So while there is no doubt that the banking crisis was severe, it has largely been averted, but now things are beginning to look bad in other sectors as well.

So how much is there about the economic situation as it unfolds right now – is the downturn created by TV coverage of the banking crisis?

I believe it is important to start with the fact that over the past years – since 2001 to be precise – the world has experienced a growth of credit without historical parallel. The impact has been visible everywhere, as cheap credit has been available globally, and nowhere more so than in the USA. However, the impact on people’s lives has critically depended on the way consumers and industries would have access to the credit. Probably, the consumers in USA and UK are the most “addicted” to credit, whereas a country like Germany has a tradition of financial prudence at an individual level. Not many years ago, buying a car for borrowed money in Germany would have led to a few lifted eyebrows. And in China, consumer credit is still only in its infancy.

One effect of years of easy credit is that people get used to it. It therefore begins to affect real economic allocation of money. Various investment projects get less scrutiny. For a family, often the most important investment in their lives is their home. In the good old days clearing one’s mortgage debt before retirement was considered a prudent way of approaching the investment.

But from the US evidence has appeared that many families began to consider their home as a short term investment rather than a place to live. Many began systematically to practice “equity extraction”, i.e. borrowing against the increasing price of the property, using the proceeds for spending.

With steadily increasing prices, with falling standards of verification from the lenders, with an unregulated process of selling new mortgages loans, it developed into a dangerous leveraging of the personal balance sheets of many American families. Through the increasingly integrated global economy, this spread to other countries as well.

One can shake one’s head and ask how this could continue, even as more and more indicators pointed to the simple fact that the price of residential property had long time exceeded the level where a normal family could afford to buy.

But the logic from the creditors was simple: the buyers (or borrowers) will profit from ever-increasing prices, so if they cannot afford the mortgage, they can always sell – and even make a profit out of it.

In most countries, buying a too expensive home quickly will put a squeeze on other kinds of consumption, not least because the banks and mortgage companies scrutinise the borrowers. There will simply be a stop for further credit. This also goes for the “equity extraction” loans.

In the US – and increasingly in the UK as well – the separation of credit card companies from the banks have led to a huge increase in credit financed consumption. It is not unusual for US families to have 5-6 credit cards and to roll the balance from one credit card over to a new credit card. As long as no delays are tracked in the monthly payments to each company, no red lights are set off. But at some point in time, of course this Ponzi scheme will come crashing down. We could very well be at that point in time, and the effect on US consumption more profound than understood by the market.

Irrespective of the poor quality of economic indicators from the US, there is no doubt that we are now well into a massive cleaning out of consumer’s balance sheets in that country. Finally, American consumers are coming to terms with the drying up of credit. The effect could be deeper than we currently think.

What makes the situation serious for the rest of the world is not only the fact that the US is a very large player in the world economy. It is also the fact that private consumption accounts for almost 70% of the US economy. Contrast this with Europe, where it is not unusual that public spending makes up some 50% of the economy and about 10% comes from corporate investment, leaving about 40% to private consumption. Hence, in a downturn (as well as an upturn), the US economy is very likely to see wider and faster swings than the European economies.

Add to this that the US consumer has had a zero or negative savings rate over the past years, fuelled by the easy credit.

The main problem about all this is that it often takes years to repair consumer balance sheets. My home country, Denmark, had an experience of the same kind in late 1986. It took the biblical 7 years before the economic situation had improved sufficiently for the economy to take off, and that even required some clever fiddling with the tax system to “help” consumers make the right savings decisions.

If this experience is anything to go by, there is no chance that the US recession will be a short-lived experience. Rules have changed for mortgage credits, property prices are dropping, pension plans are reduced in value, credit cards will be harder to come by. Car finance will not be as readily available.

My guess is that sorting out this situation will take all of Obama’s first election period. It may even cost him reelection. As a consequence rest of the world will experience a period of slower growth. I am afraid we are only at the beginning. The economic indicators will come in and show that this is more than just a feeling.

Tuesday, 28 October 2008

On request: What do I think about the markets?

Some readers have mailed me asking for my no holds barred statement regarding the direction of the markets, probably because they hope it will help them in taking positions. Here it is, but I emphatically reserve the right to change my mind as things develop. And if you do take positions on the basis of this post, it is entirely at your own risk.

Interest rates: Worldwide interest rates are heading downwards and will end up in negative territory globally, when corrected for inflation. ECB will likely be a tad slower than Fed. Some countries have gotten themselves in trouble with their currencies and will need to keep interest rates high, or choose the obvious solution of abandoning whatever pegging arrangements they have. Speculators are already picking out some of the weaker links and they will have to defend themselves with determination.

Bond yields: Government bond yields will fall as the global recession scenario unfolds. Any remaining inflation fears will quickly evaporate. Corporate bonds are more of a problem. The recent widening of lower-grade spreads over sovereign issues indicate a much steeper downturn and much higher default rates than the stock market appears to believe in. At least for the coming 24 hours. All things mortgage related will be in deep trouble and no prisoners will be taken.

Currencies: Unwinding short yen positions may still have some legs. Strengthening of dollar will eventually peter out, as the design of the US banking rescue package is as designed to weaken the currency with a dramatic easing of monetary policy. Add that there are still no signs of an improvement in one of the fundamental imbalances in the US, the current account deficit. Unfortunately some individual currencies may still be picked out for speculation. So if you are long a small currency where the central bank has been running some kind of shadow peg against one or two major currencies but still have no real swap arrangements with a big central bank, head for the exit.

Stocks: All bets are off and it is not really the time to be discerning. If you believe (as I do) that there is still a lot of off-loading to be done by hedge funds, sell into rallies, and those rallies can be strong, 15-20 per cent. If you believe that the recession scenario is now priced in, go buying. It is time to bring out your copy of Graham and Dodd’s Security Analysis. If you do not have time or patience to read that, try and find stocks trading at a market value lower than their net current assets. Dividend yield and other indicators are off, for who knows where dividends will be a year from now.

Oil: I am getting hesitant on this one after the huge fall. I do believe, however, that there is one more downside attempt left, and the geopolitical implications of an oil price lower than $50 per barrel are visible with the naked eye. It must be very difficult to sit in the US Treasury, with a newly minted shareholding in the world’s largest commodity traders, and NOT calling them to tell that a further fall would be, ahem, highly convenient. Of course not a good idea if you are still long in companies producing alternative energy technologies.

Commodities: It is the ultimate recession play and I believe that there is still a considerable downside across the board. Gold will suffer as inflation expectations wither away, base metals will suffer with the unfolding recession scenario. Reason is still not available in these markets. They overshot on the way up, and it could well be that they overshoot on the way down as well.

Emerging markets assets: have been pummelled as it became clear that the much-vaunted status of being self-contained has not yet been achieved. Next shoe to drop: these markets do not have any significant built-in automatic stabilisers as demand slows, due to the recession in the export markets. It can turn uglier, still.

Hedge funds of the long-short or equity derivative variety: I would like to believe that the worst is over. In my post yesterday I gave the arguments that there is a certain probability that it will instead get much worse. The combination of margin calls, bank deleveraging, and investors wanting to leave look deadly to me. And Paulson has made it clear that the cavalry will not be charging to help bailing hedge funds out.

Monday, 27 October 2008

Hedge Fund Tumble?

In the current stock market sell-off, a new phase appears to have been reached. Market participants have apparently given up hoping that stocks will come back up any time soon. The rather dramatic downtrend will apparently continue, and now the game is all about finding a reasonable explanation why it is so.

This being said, I tend to agree that there is a lot of companies out there trading at prices that are compatible with a deep and long recession. If this economic downturn does not materialise or if its severity falls short of what market participants currently think, the streets are littered with bargains, and some even represent that wet dream of value investors, companies selling at a market value below their cash holdings.

Unfortunately, this does not preclude a further price fall, and I am afraid I lean towards believing that they there is indeed further downwards potential, and this is for reasons linked to hedge funds.

We all know that the word “hedge” in hedge funds is but a historical remnant from a long gone period where such funds would in fact hedge parts of their portfolio. Later such funds got the more appropriate mention “long-short funds”. Among all the various categories of hedge funds, the long-short funds have always been the dominant, dwarfing all other categories. Originally this category of funds did in fact hedge some or most market risk, relying on long stock picks to provide the return.

As the number of hedge funds grew rapidly, not least because of the handsome remuneration and the near-complete obscurity about their actual positions, their returns began to look more and more like that of simple index investment, leveraged a couple of times. That was not very surprising, simply reflecting the law of large numbers.

And something else: stories began to abound that a large number of long-short funds were actually more leveraged directional bets than anything else. Apparently many funds gave up pretending to do the long-short thing, with markets powering ahead it was more attractive just to run with the market – leveraged.

It is also well known that hedge funds on top of being unregulated and deploying remuneration schemes out of line with performance, have used a quite insidious lock-up method. Their positions have apparently been so complex and difficult to liquidate that investors had to accept only to have quarterly liquidity, and often with at least a month long notice period.

Now fast-forward to the current situation. At the beginning of the year, hedge fund assets likely stood in excess of $2.75tn, and it appears safe to assume with the lion’s share in equities or equity-linked products. The goings-on around Bear, Sterns led to some withdrawals, but the brunt of the financial crisis set in just after 1 September, leaving a lot of investors with having to wait until December before they can announce the withdrawals for year end. These withdrawals are likely to be massive, given the collapsing risk appetite in the markets. Rumours and talk in the market points to the possibility of a 10-25% withdrawal. Even if the average hedge fund has lost more than 20% in value since the beginning of the year, even if not all of the hedge fund assets are invested in equity related products and even if some withdrawals have already taken place, the amounts are likely to be significant.

On the other hand, there are the banks who have extended credits to the hedge funds, often in highly incestuous “prime broker” arrangements. The banks are now under a heavy pressure to reduce risks, and obvious the hedge funds are in their sights, meeting margin calls from the lenders.

So it is obvious that we are looking at a huge squeeze here, and if my timeline is correct, we have only seen the beginning. Discerning hedge fund managers (an oxymoron?) have of course begun to unwind positions some time ago. But I have trouble believing that there is not much more to come as we come closer to crunch time around the turn of the year.

There may some who believe that some of the Bailout Money from the US government could be used to help hedge funds in distress. No such luck, as US Treasury Secretary Paulson has been adamant that those funds will go exclusively to "federally regulated financial institutions that lend money".

Already now, pundits believe it likely that up to a 1000 hedge funds may fold over the coming months, some in an orderly fashion, some will come crashing down. Some of them will have been invested in products related to credit derivatives and so on. In no circumstances it will look nice.

In order to end on a different note, try to think over what will happen to the pension funds if massive withdrawals from the hedge funds leads to a continued negative stock market. Let us assume that the market can fall another 30 per cent on hedge fund liquidations alone. The question is then: how many defined benefits pension schemes around the world will have to hit the panic button and reduce stock market exposure in order to avoid being unable to mathematically meet future liabilities?

Anybody for more bad news? I hope somebody out there will correct my line of argument here. Otherwise, stock markets will risk going from very bad to rather worse, I am afraid.

The End of Bretton Woods

At a time when pundits repeatedly invoke Bretton Woods as an inspiration for a solution to the financial crisis, the Europe-Asia summit that took place in the past days are a significant step in the direction of dismantling Bretton Woods.

To make sure, Bretton Woods is the name of a winter resort in New Hampshire where the US and the allies agreed on a new financial world order to re-establish the world economy after Second World War. It was a system based on the simple fact that the US had emerged from the war as the unchallenged economic superpower of the world. The US was the ultimate backer of a system that built on an idea of free trade, fixed exchange rates, abolishing tariffs and capital controls, the World Bank, and the IMF.

With USA as the main economic backer (and main military power) there were no objections to the fact that Washington called the shots. At least in the beginning. As time passed the system has been shocked several times, and most profoundly as the USA abolished the gold standard in 1971. Nevertheless, the US has held on to its position as the main force behind the global financial order.

Over the past decade, the USA has done much in order to undermine her own position. Prudence in the banking system was replaced by ideologically inspired deregulation leading to the current banking crisis (as admitted by Alan Greenspan). USA squandered its position as the world’s largest creditor and handed that position over to emerging China. Instead, US became the world’s largest debtor, thus depending on the world’s savers to finance the ever-escalating current account deficit. In Iraq, the limits to the military might of the world’s only superpower was clearly demonstrated.

All of this has led to Europe and China together calling for an overhaul of the world’s financial system – at a summit where the US was not invited. Russia was not a formal participant, but there is no doubt that Russia will sign on to the idea, particularly as Russia and China through the Shanghai Cooperation Organisation have been diligent in clearing away strategic differences. Obviously there are not details on the table yet. It is, however, possible to guess what will be proposed, and it will all amount to serious curbs on the American way of doing banking. That is less important than the fact that the summit has taken place and concluded in a very clear demonstration of agreement. It is an outright challenge to the USA’s position as the world’s economic superpower.

We are thus moving closer to what my friend William Engdahl doubtlessly would call “Halford Mackinders Nightmare” – a situation where all significant powers on the Eurasian continent agree on their common strategic interests. For more on this, consult William Engdahl’s website .

It is ironic that this happens a few weeks before Zbigniew Brzezinsky via a probable democratic election victory will semi-officially be elevated to the “Eminence Grise” of American foreign policy. Brzezinsky has on several occasions written about how the US has as an overriding foreign policy priority to make sure that no alliance is established between the major powers on the Eurasian continent. This representative of Realpolitik will certainly bring an acute understanding of the new global agenda to the new administration.

If the unlikely should happen, and a Republican president be elected, the message will not be wasted on the new administration. It is my guess that the rather enigmatic reports that US Treasury Secretary Paulson forced all of the nine largest US banks to accept government stakeholding even if they swore not to need this “help”, has a lot to do with preparing for this coming fight for global financial dominance.

Friday, 24 October 2008

Capitulation trades? – not yet

Quite a number of commentators have (particularly on Fridays during the last trading hours) used the term “capitulation”, intended to mean that sellers in the stock markets are now exhausted of selling and need a well-deserved rest after having “capitulated”. Thus tired of some day’s hard work, there are no more left to sell and presumably it should lead to a stabilisation of the markets.

I am afraid that this may be too early. Obviously I hope to be wrong on this one, but there are some market elements missing from this all too human explanation.

Over the past years, hedge funds have represented some 60% of the turnover in the stock market. Despite the allure of the name, hedge funds are not necessarily hedged, and the best indicator for hedge fund performance remains a simple stock market index, leveraged between two and three times. The truly market neutral or even market contrary funds are thin on the ground among the estimated 11,000 hedge funds worldwide.

Obviously, the best hedge fund managers have already long time ago unwound positions. But it is my guess that they are still only a minority. With the credit markets drying up, banks have increasingly put pressure on all leveraged investors to unwind positions or to put in more collateral. Given that most hedge funds are so-called long-short funds, but for the past two years for all practical purposes long funds, it is highly likely that there are still many hedge funds out there who are caught in exactly the same situation as a lot of amateur investors. They have seen huge losses, they did not get out in time, and now they feel it is “too late”. But they will increasingly be squeezed into action by banks tightening up on the credit.

I agree that there are many, many companies out there who are already trading at very attractive prices. We are rapidly approaching a classical value situation where companies are selling below their asset value or even below the value of their cash holdings. It may indeed be the buying opportunity of the decade.

Unfortunately that is no guarantee that the ongoing credit freeze compounded with galloping recession fears cannot force further falls in the stock markets. Beware before you step out to catch the falling piano.

The morning after

After weeks of what seemed like useless political bickering over a rescue plan that was wrongly conceived right from the start, the US bank rescue plan finally received an overhaul that made it look like what the Europeans are doing. Not that the Europeans were too quick off the mark, the attempts at agreeing a rescue package being delayed by the necessity to balance broad agreement with national political interests.

In the end reason prevailed – at least in terms of the technicalities of the rescue. The Swedish model – itself strongly inspired by the US bank rescue in the ‘30s - is by and large being implemented world-wide: Governments will take ownership stakes in return for money to the banks, guarantees for depositors are introduced or expanded, dud assets will be taken off the balances and the taxpayers will be able to recover some money once the sector recovers. Incompetent bank management will be pushed out. What is now waiting in the wings is a monumental restructuring of the banking sector where the anointed winners will be allowed to take over the weakest competitors.

This slow and grinding process will quickly be relegated to the finance pages of the newspapers. Sadly, since it is in this process the future of the global financial sector will be shaped, and the balance of financial power between US, Europe, and the rest of the world will be determined.

Meanwhile, signs are multiplying that a global economic slowdown is on its way. Financial journalists and bank analysts have managed to convince themselves that the financial crisis is now leading to an economic downturn.

Quite the contrary: financial institutions began to crack up because an economic downturn was already progressing and that created the financial sector crisis. Excessive use of instruments allegedly devised to spread the risk assured that the crisis hit everywhere. However, tightening credit conditions have obviously accelerated the downturn. Globally, the recent coordinated rate cuts had less to do with the financial crisis than with averting a global recession.

Let us establish a couple of facts: Irrespective of the goings-on in the financial sector, the US economy was heading for a slowdown. Former Fed Chairman Alan Greenspan’s policy of keeping the interest rates as low as possible paired with “innovation” in mortgage finance created an unprecedented boom in house prices and loan-financed consumption. Add that the US federal government has been running a huge deficit in the past years. Even if US corporations have been accumulating capital, the US economy has been a rollercoaster, fuelled by overconsumption. Lest anybody does not believe this, let then have a brief glance at the US trade deficit.

It is a particular feature of the US economic and political system that the enduring problem of loan driven overconsumption has not been addressed for decades. It has undermined the standing of the US in the world, turning the world’s most powerful economy into the world’s biggest debtor. Not even the US of A can on a long term escape the plight of the debtor: Reduce your consumption below your income and begin to pay back.

Anybody who has tried to be in this position knows how painful it is to tighten the belt, reduce consumption and postpone consumption one would otherwise have preferred to enjoy now. Usually one has to be careful comparing economics at an aggregate level with household economics. However, this is one case where the parallel is entirely justified. US consumers as well as the federal government will have to endure a period of bringing the books back in good order.

Rescuing the banks will make this impossible to obtain for the federal government, putting even more onus on the consumers. Households will have to save more and consume less. House prices will fall further; employment will have to increase in the short to medium term. Given the weight of the US private consumption in the global economy, slower growth will influence global growth negatively, even if the savings balance is much healthier elsewhere.

We are not talking disasters, at least not yet. If one is to believe international institutions, global economic growth will slow from 4%+ p.a. to somewhere between 1% and 2%. It will still be uncomfortable, as unemployment will increase and property prices will be heading downwards for some time. But it should be over by the end of 2009 or beginning of 2010. Chances are still that the economic effect of the global bank rescue package also counts as a quite significant stimulus package, and provided that the global financial market resume lending operations, growth will probably resume relatively quickly.

USA is in a situation different from most of the rest of the world. Its savings ratio is sufficiently low that it badly needs repair. It is possible that the next administration will aim at restoring the basic equilibrium in the economy, keeping growth below par for all of the next presidential election period. A ‘30s-like depression is unlikely. But a slow, painful period where mainly the households change their savings patterns, forced by the economic reality. It will probably bear similarity to the downturn in the 1970’s where another behavioural pattern, namely inflationary expectations had to change.

The addiction to debt financed consumption is not as pronounced elsewhere in the world (UK being a possible exception, but with much better public finances). US consumers led the party when finance was plentiful. They will now have to take the lead in the headaches and the cleaning up the morning after the party.