SUMMARY Wow. It had everything. An October that was the worst ever for some stock markets, but also contained the largest daily gains ever. A US legislator that didn’t think avoiding financial Armageddon was sufficient incentive to pass a straightforward piece of legislation. Gordon Brown, the saviour of the world. Dividends at levels last since at the time of the Battle of Britain. Corporate bonds pricing in 50% of the UKs best businesses going bust in the next 5 years. Then November dawned with Barack Obama emerging through the gloom, and the UK authorities looking like they really do understand both the current problems and solutions.
Not long ago we said:
“The worst scenarios have always been predicated on the unlikely event that politicians and authorities stand by and watch financial Armageddon unfold”
Well, it was never going to be as straightforward as waving a magic wand, and two episodes brought the credit crisis to an ugly head, and risked a banking collapse such as from the end of 1930 triggered the Great Depression (as we’ve covered in previous commentaries).
Firstly, on 15th September the US authorities allowed Lehman Brothers to go bankrupt. Banking relies on trust and confidence. That was now broken, and the global banking system began to unravel.
Then on 19th September the US Treasury Secretary, Hank Paulson, proposed the TARP, to buy the banks toxic debts. That was the good news, and markets boomed. But at first attempt it was rejected by legislators. As the proposal was debated in the following days the spectre of late 1930 came more and more into focus, and fear spread well beyond the financial markets. Ordinary people (i.e. not bankers) began to fear for their savings (the Northern Rock problem, but now on a global scale), and this was a huge shock to sentiment. TARP was eventually passed, but the damage had been done.
Since then asset classes around the globe have been driven down in particular by forced selling from hedge funds. The volatility was such that in October the US stock market endured its worst month ever, but also enjoyed its best ever week, and the two days with the largest rises. As we write there is some calm and a little recovery, but there could be bouts of further hedge fund selling in the weeks and months ahead, even if the point of maximum panic is behind us.
The not so bad
There was a rapidly unfolding banking crisis post-Lehman Brothers bankruptcy, and action was needed, fast. The spectre of late 1930 loomed larger each day. Yet we do need to keep the recent events in perspective. In a timely recent study of notable banking crises by the IMF, they identified 42 across 37 countries. Though there is no agreement on best practice in dealing with such crises, there was much overlap, both in the causes and solutions. In summary, the report highlights that: banking crises are more commonplace than you would expect, and possible solutions are relatively well tried and tested.
Then an unlikely hero emerged, Gordon Brown. Without getting too bogged down in the details, the result was co-ordinated global action which has had a clear impact. Vix, a key measure of volatility, has broken a steep uptrend, and Libor, the elevated level of which highlighted severe problems in credit markets, is now dribbling lower on most days. More of the same will ensure there is no global banking crisis and exorcise the ghost of the Great Depression.
In an environment of forced selling, outstanding value is no guarantee against further falls. Nonetheless, if the moment of maximum panic has passed (probable?) the signs are encouraging for investment markets if not, yet, the economy as a whole.
For example, the UK dividend yield is now at a level that has only been seen three times in the last 108 years, and compared to gilt yields, dividends have not been this attractive since the Battle of Britain.
Looking at earlier banking crises, in Sweden in 1992 the stock market low was one month after the Government intervention. Similarly in July 1932 the US stock market hit a low, but economic conditions continued to deteriorate until March 1933, by which time the stock market was already up 30% from its lows.
Each banking crisis has its own peculiarities, so authorities worldwide will need to continue to be vigilant, flexible, and act in concert. But there are encouraging signs. Similarly, each stock market cycle has its own characteristics, and slavishly relying on precedent has dangers. Yet there are clearly gems amongst the debris now for longer term investors, even if a sustained stock market recovery might not begin until, say, mid 2009.
Some investors are acting now, and famously Warren Buffett said on 17th October “Be fearful when others are greedy, and be greedy when others are fearful” and began to invest his personal fortune into the US stock market, something he had never previously done. More intriguingly, and less publicised, was Clare College, Cambridge, borrowing £15m over 40 years to buy shares which “have been pushed down below rational valuations”, the first time it has done anything like this in its 700-year history.
Enter Barack Obama. In the months, even days, ahead, there will be decisive action by the Democrat’s. Expect a huge stimulus, with an emphasis on infrastructure projects, to re-employ construction workers. Also expect implementation of one of a number of proposed plans to stabilise house prices, a vital ingredient for economic recovery. With Treasury Secretary Paulson out of the way, everything is possible. And the $700 billion TARP fund can now begin to be applied. These measures plus an inspiring new leader will re-invigorate the US.
GASP. Then this lunchtime came the 1.5% cut in UK interest rates. A surprise so positive it was a shock, just what is required to temper the negative shocks in September/October. The UK authorities are showing real signs of understanding both the problems and the solutions.
A painful downturn to come – and go
Nonetheless, the events of the last month or so will mean that the economic downturn will now deepen, and 2009 will be very uncomfortable for almost everyone in the real economy and, unlike in the 1990-92 recession, the SE of England will not escape. Yet the precedents illustrate vividly that banking crises (and linked recessions) come, are fixable, and go.
While we wait for the bull to return, bear in mind…
….on the other side of the current gloom is very likely a remarkable period when inflation AND interest rates will be heading towards 1%.
From an investors perspective, if there are mouth-wateringly attractive stock market yields, this is even more so the case with corporate bonds, which took the brunt of the recent forced selling.
For example, the current yield on investment grade corporate bonds implies that 50% of these top-class businesses will go bust within the next 5 years. In contrast, in the Great Depression fewer than 5% of such businesses were broke.
It looked as if corporate bonds were underpinned late in 2007, then again in March 2008, following the rescue of Bear Stearns. But the optimism of (most) corporate bond fund managers had not factored in the dramatic forced selling we saw in recent times. One of the fund managers that was never so optimistic now sees the potential as “extraordinary”, and anticipates returns of at least 10% per annum for the next three years – at the moment just the income is typically 8%, more in many cases. As ever there are no guarantees, these are risk investments.
We could go on, but being positive is unfashionable, at least for now. Even so we feel the time for panic is past, and, while we cannot control events and the markets can undoubtedly go lower, we can control our response to them. Downturns come, and go. The world beyond this downturn will feature more affordable housing, less debt, and less use of fossil fuels; all things to which, not long ago, we all aspired.