Market Reports

Market Report

By Marco Pietropoli, March 2008

We seem to be making a bit of a name for ourselves this year.  We are very happy to report that we are at record fund levels.

Our prudent position in recommending our clients invest in Fixed Interests (UK Government Bonds, Euro Bonds and Global Bonds), Cash and Gold Equities over the last 6 months has paid off. 

We are in a Global Equity Market down turn that began in late October 07 (click below for stock market movements over the last year):

( BBC Website/Market Data/Stock Markets )

It all began back in August with the credit crunch.  The news has continued to get worse as the liquidity crisis has deepened.  We have seen Northern Rock and Bear Stearns crumble and we can expect further casualties. This will not be limited to the financial sector.

The January lows in the Equity markets have been breached.  The next natural resistance level for the FTSE after this is about 5,100, where we are likely to find some temporary respite.  If this happens, this will mean that we will be approx 24% down on the highs around 6,700. 

A more substantial fall in the Emerging Markets is expected.    There have also been significant losses at the riskier end of the Debt and Fixed Interest markets.

Commodities have continued to perform well, due to the continuing demand from the Emerging Market, mainly China and India.  The safer end of the Fixed Interest market (mainly Government Bonds) have also done well, due to the demand for safer assets.

The downturn in the US economy has been coming for some time, as you may recall from our last Market Report in October 2007.  The US housing market has continued to decline and the knock on effects to the global financial system had yet to be resolved.

The individuals running things over in the US seem to have taken leave of their senses and are giving up the Dollar seemingly without a fight.  If the idea of slashing interest rates was to alleviate problems in the housing market and to rescue  the US consumer before it is too late (probably trying to rescue the economy for the election in autumn). The plan has backfired. 

Mortgage rates and overall lending rates in the US have actually increased over the last few months. This is due to the shortage of liquidity and the re-appraisal of risk.

If the banks haven't got it to lend it, the interest rates are entirely irrelevant. 

There are many Bond auctions in the US that are failing due to the severe liquidity crisis and the low yields being offered.  As interest rates fall and more of the US Treasury Yield Curve [1] drops below the level of inflation (CPI) [2]; the more difficult it will be to attract investment. This is crippling the money market system.  Further cuts in interest rates are expected, which will only make the problem worse.

US Base rates are also now below inflation.  This negative real rate of return in the short to medium term Fixed Interest market and in deposit based investments could create an even bigger liquidity crisis.

US treasury Secretary, Henry M. Paulson and the Federal Reserve chairman Ben Bernanke are not doing their country, or indeed capitalism, any favours with their proposals and actions. The idea of getting banks to forgive part of a borrower's mortgages to get people out of negative Equity, is shocking [3]. The policy of buying up the bad debt in the system is leading the US down a slippery slope [4].

Companies and individuals going bankrupt is part of the economic cycle.  The bad decisions and the high risk takings of the few should not be spread across everyone else.  There is a real moral hazard intrinsic with bailing out Wall Street and bad debtors. Capitalism simply would not work if there is no downside to taking too much risk and making wrong decisions. 

The UK is into this as well with the whole Northern Rock debacle.  Again we seem to be setting a dangerous precedent.  The country as a whole has taken onboard the debts of Northern Rock.  What will the government and the Bank of England do when the next bank has a problem?

The worst consequence of the loose monetary policy in the US is the tumble of the Dollar. The global ramifications of a plunging Dollar is quiet difficult to even comprehend.  This is fuelling a surge in commodity prices which will cripple the US consumer further.  The US economy is simply unsustainable in its present state with oil at over a $100 a barrel.

Our client holdings in Gold Equities have performed well due to this, but it is still unbelievable to witness. 

The US had a difficult choice.  Save the economy or save the Dollar.  It is clear which decision has been taken.

Finally the markets are pricing in the fact that US is in a significant down turn.  Jobs are being lost in the US but strangely enough, unemployment seems to be coming down and wage inflation seems to be still in the system.  The logical answer would be to suggest that maybe immigration to the US has gone into a reverse. 

A very significant proportion of the working force in the US was not born there.  It would make sense if people are leaving the country if the jobs are drying up, the property market continues to fall and there is no proper welfare state with a comprehensive health system.

How does it all effect us and the rest of the world? Well the UK is next I am afraid.  We work on a fairly similar basis to the US and have also created a credit bubble backed by rising property prices. The British are heavily in debt [5]. Therefore if you haven't got it in savings and you can't borrow it because of the credit crunch; you cannot spend it!   

The UK Government has not put aside much in the way of reserves in the time of plenty [6].  Therefore any fiscal stimulus in this down turn is likely to be minimal as governments simply cannot afford it.  

We believe that the Euro zone may well be driven into a recession by the ever strengthening Euro and also due to the squeeze on credit. 

Japan would also seem to be in a sorry state, as they do not have the ability to substantially lower interest rates in this down turn.  Their base rates are already at 0.5%.

It is difficult to contemplate how the Emerging Markets won't be significantly affected by a recession in the US and in the rest of the G7. As things stand, the Emerging Markets are still growing substantially faster than the more developed markets.

There will be real opportunities, though, in Equities this year. 

So who has got all the Cash then?  Well certainly the Russians, the Middle East and the Chinese are not short of liquidity.  The Chinese hold over $1.46 Trillion (November 07) in Cash and Investments that they can use to keep their economy going through this turbulent time [7].  The only problem with that of course is that a lot of these funds are held in Dollar based assets. Destroying the Dollar further by selling these investments may end up being counter productive.   

I hope this hasn't made you all slit your wrists and you don't think the world is coming to an end.  There are always investment opportunities for those that are well placed. Volatility is not something to be feared but to be used to one's advantage. 

Recessions are meant to happen regularly.  The economic cycle is traditionally about eight years.  The last slowdown was in 2001 but did not result in a recession in the UK.  We have to go back to the late 80's or the early 90's for the last proper recession.

Property prices in the UK are likely to go down in the near term but are unlikely to crash as interest rates are historically fairly low and unemployment is also very low.  If unemployment were to rise, this would of course change the situation. This is assuming the credit problems sort themselves out sooner rather than later.  If the credit crisis continues for significantly longer, the downside risk will increase. 

We would seem to be heading into a period of stagflation. This is defined as a period of high inflation, low growth and rising unemployment.  The 70s are probably the best example of this.

Somehow we need to get through this financial crisis.  Then we need to understand what the global impact is of the US sliding quickly into recession and a tumbling Dollar.  This may take at least six months to a year to understand so volatility will continue for the foreseeable future.

The US needs to find a way of uniting at the election this autumn.  If the election divides, rather than unites, the possibility of significant civil unrest will increase substantially.

References:

 [1] Bloomberg.com – Rates and Bonds/U.S. Treasuries http://www.bloomberg.com/markets/rates/index.html

[2] United States Department of Labour – CPI Data Released Friday, March 14, 2008
http://www.bls.gov/news.release/cpi.nr0.htm

[3] Bloomberg News – Article - Last Updated: March 4, 2008 18:15 EST http://www.bloomberg.com/apps/news?pid=20601087&sid=aAenLxs5eXcE&refer=home

[4] BERNANKE IS GOING TO RUN OUT OF BULLETS by Dan Denning http://www.liveleak.com/view?i=d79_1205881538

[5] The Metro Newspaper Article - Wednesday, March 19, 2008 http://www.metro.co.uk/news/article.html?in_article_id=122794&in_page_id=34

[6] The Telegraph newspaper – Article Last Updated: 1:11am GMT 22/01/2008 http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/01/22/cnborrowing122.xml

 [7] Financial Times News – Article - Chinese cash turns in new directions, By Peter Garnham Published: November 30 2007 02:38 | Last updated: November 30 2007 02:38

http://www.ft.com/cms/s/0/ad5f9256-9edd-11dc-b4e4-0000779fd2ac,dwp_uuid=9c33700c-4c86-11da-89df-0000779e2340.html

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 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 east 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.