Right now the global financial system is dangerously unbalanced – but help appears to be on the way, says Guy Monson
The recent exceptional market declines combine fears of the ‘unhinging’ of the financial system on one side, with quite extraordinary pools of global liquidity on the other. We have ‘capital starvation’ on Wall Street at the same time as unprecedented levels of foreign exchange and sovereign reserves in Asia and the Gulf. And, while banks suffer, the corporate earnings and cash flow from many industrial blue chips are close to record levels. We have, in other words, a dislocation of global liquidity. The actions of sovereign wealth funds in recapitalising US investment banks are the beginning of the solution, but aggressive central-bank movements are also required.
The first half of January saw an accelerating downward momentum and a surge in volatility across global equity and financial markets. This reflected a growing fear of contagion as the rating agencies continue to downgrade structured finance products and draw in the very companies (including bond insurers Ambac and mbia Inc) that guarantee so many other underlying issues. Indeed there was a growing feeling that the problem was ‘open-ended’ and that a policy of simply reducing exposure to vulnerable institutions was no longer adequate.
In response, investors have been using futures aggressively (volume has been very high) to make blanket reductions in equity exposure, while bank and insurance stocks have typically suffered hard, double-digit share price declines. Most of these losses have been in response to a series of ‘confessionals’ as banks have owned up to likely sub-prime write-downs.
So what are investors to make of the worst annual start for world equity markets in more than 40 years? On the one hand it could hardly be worse: a mushrooming financial crisis, a US housing slump and perhaps a Japanese recession. In addition we have the most open and complex (from a policy standpoint) US election outlook in 50 years.
But it could also be worse: over the last week, banks have raised $79 billion (much of it from sovereign investors) to cover around $100 billion of write-offs, inter-bank rates have narrowed considerably, and Fed chairman Ben Bernanke has stated that he stands ready to take ‘substantive action’ to ‘insure against downside risks’.
The problem for investors has been that, despite encouraging comments from central bankers and extraordinarily optimistic interest rate futures (suggesting that, by the end of April, US rates could fall to three per cent and European rates to 3.75 per cent), there are few concrete signs of market stability. Ironically, the perceived risk is now coming more from areas that require (if done swiftly) only limited capital backing.
For example, this year’s 75 per cent decline in the shares of Ambac Financial, which provides financial guarantees to bond and structured finance issues, amounts to a loss in market value of just $4.5 billion. This is a tiny sum in comparison to the hundreds of billions wiped off stock markets as investors worry about the consequences of the issuers themselves being downgraded.
Action by the authorities to support these fragile links in the financial system would be very helpful. Expect coordinated central-bank action, aggressive rate reductions and direct market intervention (probably led once again by the European Central Bank). The Bush White House is likely to implement a fiscal plan of tax cuts. In the medium term, this increases inflationary risks, but there is no indication that this will hinder policy over the short term.
So what should investors do? First we must remember that large sections of the world markets continue to enjoy an extraordinary run of growth. So far, 62 of the s&p500 companies have reported their fourth quarter earnings. These have averaged a decline of 18.1 per cent but, if one excludes financial stocks, the underlying growth rate is a positive 12.6 per cent.
Standout results include General Electric, which reported revenue growth of eighteen per cent in the fourth quarter. IBM expects fifteen to sixteen per cent earnings growth for 2008 (up from a previous guidance of fourteen per cent). What is clear is that companies that have significant global earnings exposure are reporting strongly. Jeffrey Immelt, the CEO of General Electric (which has a market capitalisation of apporoximately $346 billion), stated in his recent report that, ‘Every place we went there’s a need for power, there’s a need for planes, there’s lots of capital being invested, and there’s just no sign this global infrastructure boom is slowing at all.’ In other words, there seems to be no indication of a material slowdown in the earnings of large, global growth stocks.
Secondly, equity/bond valuations are at or close to 30-year lows across most major markets – buying best-quality equities has rarely been cheaper. Investor sentiment measures (which are good contrarian indicators) also suggest a heavily oversold market, while a growing inflation risk in the years ahead is not priced into ten-year bonds that now offer negative real returns for tax-paying clients in almost every major market. Thirdly, a controlled sell-off in energy and metals prices should start to alleviate the pressure on US consumers, while a firmer US dollar gives the Federal Reserve greater flexibility to further loosen domestic monetary policy.
Finally, in the event that concerted intervention by central bankers leads to rising bond yields and falling credit spreads for financial stocks worldwide, we will start to lift our equityweightings overall and buy what we see as unprecedented long-term value in global blue chips worldwide.