The credit crunch and demise of the Great United States

By Marco Pietropoli, November 2007

The cat is finally out of the bag. The aggressive 0.5% interest rate cut by the Federal Reserve only a few weeks after they were happy to tell the world that inflation, rather than a slow down in economic activity, was their biggest threat. Back in the spring Mr Bernanke, the Federal Chairman, and Mr Paulson, the Treasury Secretary, had stated that the credit worries in the sub prime were contained and therefore should not cause significant financial turmoil.

The credit crunch started at the beginning of August and the upheaval we have seen in both Money markets and Equity markets are direct results from this. The best way to explain what has happened to the Money markets is by looking at the GBP 3 months LIBOR rate (The Inter Bank Lending Rate) in the last year. http://www.thefinancials.com/Samples/i001265v.PDF

You can also see the Dollar ($), Yen (¥) and Euro (€) LIBOR rate by looking at our market date page. http://www.rmwm.co.uk/market_data.htm .

Suddenly and practically over night, financial institutions started holding on to their cash and effectively the Money markets stopped functioning properly. The Inter Bank Lending Rate has returned to normal levels but we are not out of the woods yet.

So what is causing all these?

The housing recession in the US has exposed poor lending practices and we are now experiencing the knock on effect in the financial sector. The property market in the US is set to continue in a downward trend for the near future with some analyst predicting that it will carry on till 2009. Therefore mortgage defaults are likely to carry on weighing on financial institutions.

The central banks across the planet have pumped billions into the money markets to ease the liquidity problem but the issues are far from solved.

There are grounds to believe the US economy is heading in to recession as Alan Greenspan, the old Federal Chairman, had predicted at the beginning of the year. Most indicators are lagging indicators and therefore it may take a couple of months for the data to come through.

So why is the US in so much trouble?

• They are the most energy inefficient country on the planet. History may show that by not signing up to the KIOTO treaty on climate change and fuel efficiency, at the beginning of the Bush administration, may not have been a good idea. The US is now years behind the rest of the developed world and the impact of rising fuel costs will continue to take its toll.

• Problems in the manufacturing sector: The US manufacturing sector will continue to loose the battle against cheap imports from the Emerging Markets namely China and India .

• Negative trade balance: The US imports far more than it exports and therefore money is effectively flowing out of the country. This will continue to result in a weak dollar.

• A crippled executive: Due to an anomaly in the US constitution where there is a Democratic Congress and a Republican President with a VETO, no meaningful legislation will be passed until some time after the next presidential election.

• Expensive wars: The US is now spending a quarter of it's budget, more than $700 billion a year on defence. They are stuck in Iraq and Afghanistan for the foreseeable future which means there will be less money to sustain the economy in the downturn that is underway.

• A political move to the left: The Democrats are fairly certain to win the next presidential election which will undoubtedly result in a discussion about providing universal health care and other social reforms. Any belief that it can be achieved without higher taxation is not only misguided but irrational. Higher taxation will mean money will be leaving the United States . The Democrats also have a history of protectionism. If they go down this route again, this will have a hugely damaging effect.

• No safety net: Unlike rest of the western world, the US does not have a comprehensive welfare state. The US consumers who are now worried about their jobs, experiencing falling house prices and facing a squeeze on credit may soon reduce their spending. The US consumer drives the majority of the US economy and the government is in no position to provide a safety net for these people. 40% of the US workforce was not born in the US . If the jobs dry up and the property prices continue to fall and the government does not seem to care, immigration could go into reverse. This will have a further damaging impact on the US housing market, the dollar and consumer spending.

• The continuing fall of the dollar: Most of the currency reserves on the planet are held in US dollars. The dollar is effectively supported by foreign investors as it has been the traditional safe haven for investment. The worst performing investment sectors over the last 5 years have been dollar based deposits and fixed income investments. The question still remains, how long will investors take losses in these sectors before pulling their money out? Well the exodus has begun.

• Damaging foreign policy: Politically speaking, the US has very few friends left and will therefore have little sympathy in times of crisis. It's inability to proactively engage with the rest of the world has damaged its international trade.

• The emergence of the Euro: The Euro is now the real alternative to the Dollar.

• The rest of the world is doing well: Twenty years ago, investors had a far more limited choice of where to put their money. There are many emerging markets that provide far greater potential for growth than the US .

So where does that leave us?

We hope that that the demise of the US will not be too rapid as we will all feel the pain shortly after. The US still represents the bigger buyer of goods and services in the world and it is therefore difficult to see how a significant slow down of the US economy will not have a knock on effect.

We feel that there is still value to be had in the Equity markets over the next 12-18 months but we would also recommend that some of the profits made in the last 4 years should be taken and invested in alternative assets like Fixed Interest and Commodity based investments, such as Gold. It is likely that volatility over the next 12-18 months will be higher than that over the last 2 years. It is therefore a very interesting and potentially lucrative time for those that can position themselves correctly for the swings to come.