Observations on a Crisis
Posted on: Sep 22nd, 2008 | By Niels Jensen | Filed under Politics & Economics
Observation # 5
The final shoe hasn’t dropped yet.
One of the most heated debates of recent months is whether the commodity bull market of the past year has been driven by economic fundamentals or it is just another case of greed caused by “a couple of handfuls of hedge funds” which seem to get blamed for pretty much everything these days.
Readers of the June 2008 Absolute Return Letter will know our take on it. There is no way that fundamental factors alone can explain the rise in oil prices we have experienced in 2008. That has always been our view and the rather steep drop in the price of oil since I wrote the June letter has only served to reinforce our beliefs that the oil price still has some way to go before the fundamental equilibrium price has been reached.
Despite some masterful attempts to convince us of the opposite, the global investment banks have failed miserably to persuade me that the commodity bull market is (mostly) based on fundamentals. To me, it still represents the last leg of the liquidity super cycle which has been in full vigour ever since Greenspan decided he couldn’t distinguish a bubble from a mere bull market.
The first shoe that dropped came off the credit leg. Then the property shoe dropped to the ground rather ungracefully and, in recent months, the equity shoe has fallen off as well. Only the commodity shoe is still attached to the four legged beast and only just. What I find most interesting, though, is that the most vocal supporters of the notion that the bull market in commodities is driven by fundamental factors are the same investment banks which stand to lose the most, should commodity markets collapse (see chart). Case closed.
Chart 5: Investment banks’ exposure to commodities
Source: The Economist
Observation # 6
Leverage is ‘dead’ but capital is not.
The global pool of capital continues to be quite strong, primarily driven by a continued rise in the global savings rate. Although American consumers have not yet discovered the need to save more, in other parts of the world, the penny has dropped, and the global savings rate (as a % of global GDP) is well over 20%. This will soften the impact of the crisis as these savings can be made available for new investments.
The question is whether investors around the world have the appetite for allocating this capital to where it is most needed – to re-capitalise the world’s banks. As long as asset prices, and most importantly property prices, continue to fall, then investors will fear that we haven’t seen the last of the big write-offs yet. And without a re-capitalisation of the large banks, the global economy will only fire on four of its eight cylinders; hence the absolute necessity for property prices to stabilise before we can realistically hope for better times.
Observation # 7
The end of the crisis looks further away than it did a year ago.
As pointed out by Larry Summers in a recent article in the FT2, policy makers are still behind the curve, mostly as a result of the commodity-induced rise in inflation which has made it difficult for central banks around the world to stimulate economic growth through a reduction in interest rates.
This view is reinforced by an observation made by Joachim Fels in a recent research paper produced by Morgan Stanley3. Fels points out that real short term interest rates (which he defines as the policy rate minus consumer price inflation) are currently negative in 20 of the 36 countries in Morgan Stanley’s (MS) research universe. Monetary policy is hence more accommodating than many investors realise – particularly in North America, Eastern and Central Europe and across Asia – and there is little room for the authorities to cut rates aggressively.
This brings me back to a point raised earlier. When banks struggle, the usual fix is a steeper yield curve. The simplest way to do this is through a reduction in short term rates. With the yield curve already quite steep in the U.S., the current environment should in principle be conducive to making lots of profit for U.S. banks. The fact that they don’t, illustrates the extent of the current problems. Therefore do not expect a further reduction in the policy rate to fix the problem. We are dealing with a different kind of beast in this crisis. An accommodating Fed (or, for that matter, ECB or BoE) won’t necessarily make the crisis go away!
Observation # 8
Traditional risk management has lost its way
Last but certainly not least, it has become crystal clear to me that the general approach to risk management has lost all credibility over the past twelve months. Paul McCulley of Pimco touched on the subject in the July 2008 issue of Global Central Bank Focus:
“[...] every levered financial institution – banks and shadow banks alike – decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense. At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed.”
As I pointed out in the October 2007 Absolute Return Letter, the issue at heart is that returns in financial markets are not normally distributed, but the risk management tools which are used by pretty much everyone are based on the assumption that they are. In a brand new book authored by Cuno Pümpin and Maurice Pedergnana4 the authors make the following point:
“The tragedy of the worst financial crisis since the 1930s was enhanced by almost every investment bank, all rating agencies and all bank regulators using the same measurement and the same mathematical risk model for market evaluation of securities. This example shows how dangerous the use of the standard deviation based approach is. If most of the market participants make decisions based on the same risk control of a false distribution assumption, and oversimplified risk model, it could cause a complete failure of the system.”
I believe this book is one of the most important new books out this year. Few investors understand risk better than Pümpin and Pedergnana. Unfortunately, the first edition is published only in German. However, the authors are keen to get it translated into English as quickly as possible. I will keep you posted.
Conclusion
With the global banking industry bleeding, with galloping inflation limiting the options of monetary authorities, with house prices showing no signs of recovery and with policy makers set to repeat the mistakes of the past, it is hardly surprising that we find it difficult to be bullish about the economic outlook.
The first stage of the credit crunch is now all but over. Forced liquidations are no longer an everyday occurrence and hence some sort of normality has returned to global markets. The big question going forward is how much damage has been inflicted on the real economy?
Over the summer, the world has gone from being quite sanguine about economic prospects to being very negative. However, the economic data points are all over the place: In Denmark, the leading financial newspaper ran with the following header yesterday: “The economy grows again – the recession has been cancelled.”
You’d better get used to this sort of story. There will be several false dawns before we finally come through this crisis. And the recovery is still quite some way away. The consumer is in for another shock in a few months’ time when the heating season kicks off again. We find it hard to believe in any sort of recovery until the spring of 2009 at the earliest.
On the other hand, if the economy does recover next spring, then the turnaround in global stock markets is not far away, as it usually leads the real economy by 6-9 months. Having said that, what would you rather own? Equities which currently trade at 15-20 times earnings or credit instruments trading at a fraction of that cost? Deutsche Bank has calculated that senior secured loans are now trading at an implied price earnings ratio of about 5 – less than a third of the cost of equities. There is no question that the real value is to be found in credit instruments. This is where most of the damage has been inflicted and it is where the big bargains are in today’s market.
Source: Observations on a Crisis
