SUMMARY. In September 2008 a relatively straightforward downturn in the real economy met a deeply intensifying banking crisis. A breathtaking month. The extreme turbulence has continued into October. Here we review what went on (as briefly as events allow!) and set out chinks of light.
In September 2008 a relatively straightforward downturn in the real economy met a deeply intensifying banking crisis. A breathtaking month. Even The Sun appeared to run out of superlatives on its front page. The extreme turbulence has continued into October.
The days of debate over the Troubled Asset Relief Programme (TARP) left no room for doubt that creditworthy US consumers and businesses, big and small, were being denied credit; a real credit crunch, contradicting the comment of the US credit union quoted in our last note. But it was something much more serious that Henry Paulson and Ben Bernanke sought to prevent with TARP.
Yet, as Lex put it in the FT, “avoiding financial Armageddon is, apparently, an insufficiently ambitious goal”, and the House of Representatives failed to pass the proposed legislation. This defining moment allowed a number of days for sentiment to bubble-up to a historical frenzy, as a range of worst-cases were aired, very publicly. The consequences are still being felt today.
We begin with a review of events from mid-September, and then move on to consider the most recent days, and the picture that is emerging.
Death by headlines
The week beginning 15th September opened with the headline “Fight for survival on Wall Street”(FT), as Lehman Bros was on the verge of bankruptcy, and, reflecting on Mondays events, the Daily Telegraph screamed “Meltdown Monday”. By Thursday “Panic grips credit markets” (FT), as Lloyds TSB was egged on by Gordon Brown into a takeover of HBoS, and, with a flight to quality, yields on US Treasury’s hit lows last seen when Germany invaded France. It was a week of bank failures, rescues and capital injections on a scale unimagined even days earlier. But action was piecemeal and the authorities were continually playing catch-up. So when the US proposed a $700bn nationalisation of the banks toxic assets “Global markets roar in approval” (FT), and “Fill your boots” exclaimed The Sun‘s front page.
Monday 22nd was the beginning of a tense week, with the spectre of the Great Depression, triggered by a widespread collapse of the banking system, hanging over Congress, the US, and the globe. No one believed that the rescue package would not pass. The debate became fractious as the week progressed, but a positive vote was still expected on the following Monday, 29thSeptember.
In the UK that following Monday morning we were graced by an intelligent rescue of Bradford and Bingley, orchestrated by the Government, and suggesting they were (perhaps for the first time) getting ahead of events. Any optimism was short-lived, with the extraordinary rejection of the US rescue plan (TARP) by the House later in the day.
The Sun says “Blackest Monday”, seeming to run out of superlatives. We were told it was the biggest fall ever for the Dow Jones; in fact it was nowhere near in percentage terms. Judged by the S&P 500, the far more representative US index, it was the 20th biggest fall in one day. Nonetheless, after days of unremittingly gloom-laden analysis, soul searching and introspection, this was a very real global shock. By the end of the week a revised version of the TARP bill was passed in the US, but in the meantime there were days for the widespread gloom to become entrenched. Confidence had suffered a shock too far.
Confidence visibly hit
From the perspective of the UK, and much of the world outside the US, a banking crisis on the scale of 1930 onwards, which allowed a cyclical downturn to morph into the Great Depression and an unemployment level of 25%, had become horribly possible. Would this shock hit confidence and the behaviour of consumers and businesses, deepening and prolonging a downturn which need not have been too troublesome?
Weekly sales figures of John Lewis provide an immediate indicator of consumer behaviour, a window on to the real world. These clearly showed the change in behaviour in May/June in the wake of the inflation shock, and equally gave a sense of the ship steadying through the Summer. This pattern was replicated by one bellweather corporate in the business-to-business market that we monitor.
But the sales at John Lewis fell sharply, year on year, for the week beginning 15th September, and fell even more sharply in the following week. With consumers responsible for 70% of the UK’s GDP, their behaviour is vital.
Last time we highlighted the feedback from two fund managers at the coal face that, surprisingly, non-financial companies are not struggling to get access to funds, and tend not to be using the credit facilities that are already in place. Even so, the behaviour of the High Street banks is also influenced by these nerve-jangling events, and in recent days increasing numbers of small businesses have reported that banks have been sharply increasing overdraft costs.
Downturns are fast, recoveries slow
A large shock to confidence, sufficient to trigger such a rapid and substantial change in behaviour, as evidenced by those John Lewis numbers, is not quickly turned around.
Downturns are fast, recoveries are slow. Nonetheless sharp cuts in interest rates will begin to lay the foundation for an eventual economic recovery, as will large-scale intervention to stabilise markets and get their travails off the front pages.
This is the first major economic downturn to be played out under wall-to-wall, 24 hour, media attention. Some of the more hysterical reporting does erode that vital confidence ingredient, and this should not be ignored, least of all by the media themselves.
Last weekend (Saturday 4th October) it was encouraging to see OJ Simpson grabbing the headlines, or, if you are a reader of The Sun, you would have enjoyed front page photos of Peter Mandelson and Gordon Brown below the headline “I’m right behind you”. Almost a return to normality, and hopefully not fleeting.
Opinion thrown around like rag dolls
Some hugely experienced economists and analysts, for whom we have the greatest respect, have had their opinions flung around like rag dolls. Doom-laden one day, optimistic and hugely relieved the next, and then despair, and so it went on.
Events on this scale are so rare, it is very difficult to identify the one or two elements which enable appropriate parallels to be drawn with earlier times. Our view is that the most potent shock to consumers and businesses from late 1930 (finding your bank locked against you, refusing you access to funds or credit, with the threat of losing your life savings) is the, thankfully, key missing ingredient today. It was not so much a credit crunch in 1930 and beyond; rather a banking system that was broke, and broken.
Clearly this is not only understood by Ben Bernanke, but also the Irish Government, who provided leadership from an unexpected quarter last week by providing a 100% guarantee for savings in Irish banks. Even more significantly, but less publicised, they will guarantee new bank debt issued until 2010.
While the hope for a shallow (albeit prolonged) downturn might now appear forlorn, we are a long way from 1930 as long as Governments and central banks continue to deal dynamically with the banking crisis, and the evidence abounds that they will do so.
Events catching up with stock market valuations
The economy is one issue, the stock market is another. The stock market anticipates, and discounts, the outlook for the economy and profits, perhaps 12 months ahead.
For some months many analysts have felt that stock market valuations were discounting a sharp economic downturn which seemed unlikely (and it was therefore cheap), and the bond markets were priced for something even worse (and outrageously cheap). The events of the last two weeks certainly justified the caution built into stock market prices (if not the bond market).
Equally, at some point markets will begin to recover, anticipating an economic recovery. At the point when this occurs it will feel quite bizarre, because that market recovery is likely to begin about the time when the real economy is at its worst.
Chinks of light
The action by Governments and central banks is very encouraging, though their determination could be usefully matched with more co-ordination.
The end of market falls on this scale are typically marked by widespread fear and panic. The most experienced, successful, and clear-thinking investors know this, and evidence of them buying should be very encouraging.
For example, on 23rd September Warren Buffet invested $5bn in Goldman Sachs, where he had largely avoided banks since the early 1990s. On 1st October he also agreed to buy $3bn preferred shares of General Electric.
Another good example, is the bitter battle between Citigroup and Wells Fargo over Wachovia, the US’s sixth largest bank.
It was some time ago that we identified the range of 4500-4800 as an area of support for the FTSE 100 index. Now we are there. The dividend yield on the FTSE 100 index is now 5%, and the interest on a 10 year gilt is 4.2%. The latter gives you a fixed income and no opportunity for growth of the income or capital. The former gives you a noticeably higher income to start, plus the likelihood (probability?) of income and capital growth over the 10 years ahead. This highlights compelling value at current stock market levels.
Such value only ever appears when fear and panic drives the market, rather than more sober analysis.
As Anthony Bolton put it, “the real lesson in times like this is not to be shaken out when the environment is very uncertain, because these are the conditions that make the lows in stock markets”.
At some point there will be a vicious bounce back. It might not occur this week, but it could be triggered by a range of Government actions, possibly co-ordinated globally, which seem likely within the weeks immediately ahead.