China grew at 9% in the September quarter, despite running at 25% less capacity (due to attempts to reduce pollution during the Olympics). "Slowest Pace in Five Years", bloomberg reports.
The current market sentiment is apparently this: We had expected China to grow exponentially and infinitely (boom-time thinking) and now, all we see is downhill, with blame falling on the US-induced 'global recession' and a pullback from an overheating economy. Even Rio Tinto's Tom Albanese is cautious near-term.
But for those with a conviction on the China story (a huge population adjusting to a higher standard of living, and a domestic-focussed, insulated economy), surely this is the time to place contrarian bets on negative sentiment?
And since when was 9%pa slow?
When is fast growth not fast enough?
Disentangling Forces
Last August, we saw the first bump in the road. Interestingly enough, at the time, everything seemed very severe. The Dow Jones had hit a high on July 19, 2007 and shortly thereafter was the first panic as the word 'subprime' entered the public lexicon for the first time. US housing prices, inflated by purchases only made possible by cheap credit and lax lending standards, began to soften. US foreclosures increased and the value of RMBS (Residential Mortgage-Backed Securities) fell.
At the time, it was suggested this was the beginning of a credit crunch - a contraction in the availability of credit to lower quality borrowers. Of course, fully secured lending would be fine. We now know that all forms of funding have been affected by the contagion of the credit crisis - even GE is struggling to survive.
In 2007, we were dealing with a financial crisis. Some feared that this would spread to the real economy, others predicted otherwise. The former were correct. Now we need to disentangle the ongoing financial system crisis from the rot that is settling into the real economies of the western world.
THE CREDIT MARKET
Every gun, cannon, rocket launcher and nuke has been fired by the authorities of the governments and central banks of America, Europe and Asia. Now, we are even seeing some kind of co-ordination amongst governments, behind the political posturing.
THIS MARKET WILL UNFREEZE 'SOON'
Monetary policy will have an effect in time - even if we can't see beyond the woods now. Banks will start lending to each other. How can they not? INTERBANK LOANS ARE NOW BEING GUARANTEED. What is more, if the banks don't begin to do something, they will begin to lose business. There will be a tipping point, where the risk of doing business is outweighed by the risk of not doing business. That time must be soon. As you can see in the chart below, LIBOR spike heavily as the banks stopped lending to each other. This has edged off a tad in the last few sessions.
Panic is driving stock markets down worldwide. Much of it is to do with the freezing of the financial system. If this problem were confined to the financial economy, 'soon' would be a good time to reinvest. The bottom of the credit crunch would be the bottom of the stock market. BUT...
ECONOMIC (lack of) GROWTH
The pain in the financial system has spread irreparably to the real economy. Jobs are disappearing in the States. Unemployment is at a 5 year high in America. Anecdotally, look at the wave of job cuts in the finance sector in London too. Asset price deflation, causing a loss of wealth, is psychologically very important to consumer spending. The ability to continue spending on borrowed money is out of the question. Make no mistake, America is in for a prolonged recession, and so too may be England and Australia, among others.
For this reason, the bottom of the credit market, once found, will not lead to a sustainable rebound in the shares of those companies pinned to the fortunes of western economies. Defensive stocks, anyone?
What of the Asian economies, however? And, moreover, those companies leveraged to the fortunes of Asia, including Australia's resource sector. The resources sector has been hammered, but a confluence of factors mean there could be a new reason to enter…. More on this next time, but in brief:
- Demand side not as bad as predicted: China's economy not dependent on the US (just ask BHP!)
- Supply-side shortages again: Credit crisis has wrenched new investment to a screeching halt - look forward to another period of supply shortage in the future
- Oversold commodities prices (eg copper)
- Oversold Australian dollar offers foreign investors a currency gain
The consequences of the $700bn mistake
The purpose of Paulson's Bailout plan
The aim of any plan to restore the financial system must be to restore confidence and liquidity in the debts markets foremost, recapitalise the banks and control the effect of mark-to-market losses on hard-to-price assets. These assets are the 'toxic' debt creating the fear which has stopped banks lending to each other, resulting in LIBOR spiking last week. Fundamentally, these assets were highly mispriced (overvalued) during the credit boom and now, due to the lack of liquidity (trust), they are not even priceable. The goal must be to foster the conditions to create a market again for these assets, such that there is a discoverable price, and a reduction in the perceived risk of interbank lending.
However, the bailout plan appears to miss the mark by focussing on stopping gaps rather than solving problems. While it is admitted that a frozen credit market will have severe real-world implications, the merits of the use of $700bn of taxpayer money is questionable. The market response post the 'yes' vote is telling: the only increase in liquidity is in government bonds (a combination of being a safe haven and the issuance of new securities to fund the plan); the sharemarket is clearly telling us it isn't convinced; and moreover, the VIX (volatility index) is hitting unknown highs, meaning that the financial system is perceived as riskier and shakier than ever.
Where the plan has gone wrong
1. Inflation causing 'real' decrease in wealth above and beyond the nominal impact
The bailout will dilute the value of the USD, because the Fed doesn't have the reserves itself to carry out the proposed bailout. Printing money - or creating new treasuries - increases the nominal value of the USD in order to 'inflate away' debts, but will cause high systemic inflation. Of course, in the current environment, wages will not rise to keep up with inflation, while the economy is in recession, meaning Americans real wealth will decrease significantly. America has been one of the world's hungriest consumers post WWII and we are witnessing the break in this chain - one of the major reasons for angst and volatility) in sharemarkets across the world.
2. Distortion to the credit markets
One of the key goals of the bailout package was to kick-start the operation of the credit markets - to provide liquidity in the quasi-dry commercial paper market. However, just as electricity passes along the path of least resistance, so too do funds injected into a broken system. The issuance of treasury paper - seen as much lower risk than corporate bonds (look at the crisis in confidence at GE for instance) - has just meant that available funds have been invested in treasuries. Instead of a kick-start to all credit markets, activity in commercial debt has continued to fall, as money shifts to treasuries.
3. Government Spending Wasted
A Demand-side approach to recesssion/growth management suggests that government spending (the 'G' in the Aggregate Demand formula) can be used to help stimulate the economy. The theory is that government spending will be multiplied - infrastructure projects, for example, will employ workers, who will go on to spend the money in other areas of the economy. Alternatively, tax cuts or well-directed welfare grants can give consumer spending a boost, also with the associated multiplier effect benefit. The bailout plan, on the contrary, utilises government funds (ie taxpayer money) to fill what is essentially a black hole.
There are two issues here. Firstly, to boost aggregate demand, we would need to accept that the benefits of the bailout would 'trickle-down' to the consumer level. Unfortunately, the money is essentially being used to shore up money in financial institutions which have found themselves in a situation of infufficient capital backing. The money, then, reaches financial institutions and stops there. There will be no effect on demand, and certainly no multiplier effect. The government loses its chance at fiscal stimulus.
The second issue is that the structure of the rescue package would actually serve to prolong the downturn. $700bn divided across every US taxpayer is aroudn $2000 per head. Even if the presidential candidates are promising further tax cuts now, this will prove impossible by the time whoever wins takes the reins of the economy. The fact is, there is now an 'extra' $2000 which each taxpayer would have to pay in order to cover government spending as it was tracking pre-crisis.
4. Where to from here
The underlying fault with the US Government's chosen course of intervention is that it failed to recognise a) that the current problems stemmed from a prolonged period of cheap credit, which served to inflate the asset prices that were later used as underlying security for further debt (a virtuous-cum-vicious cycle); and b) that without addressing the cause of the problems, we will not see a return of confidence to the market. Contrary to Bush's claim that without the 'bailout', a failure of the banking system would cause a 1930's style depression, it is in fact a failure to arrest the spiralling real wealth of the American consumer (lack of economic stimulus, asset deflation, consumer price inflation), relative to their debt levels, which would send us there. That is not to say a decrease in real wealth is avoidable: it will absolutely be necessary for the American economy to feel significant pain in order to re-adjust for past excesses.
It is essentially the ability or otherwise of the American consumer/taxpayer to repay their mortgage - or at least the market's perception of their ability to do so - which affects the price of the very assets which spread surreptiously throughout the investment world, and have now become malignant, affecting the viability of financial institutions all around the world.
Couldn't happen to a nicer person...
You couldn't hope for anyone else to be responsible for the current crisis
When is the time to buy?
As asset prices fall, should we be looking to a new level of pricing, or should we be taking up opportunities?
One factor dragging prices down into 'oversold' territory is redemptions from funds - fund managers need to be net sellers in order to meet client redemptions, ensuring that the supply/demand equation puts downside pressure on prices.
We can probably expect a new wave of redemptions as investors receive their September Quarter results. Hence we're not at the bottom yet!
[Update: Hedge Funds Prey on Rivals]
Banks Spike USD LIBOR
Paulson's plan is rejected by the Senate during an intriguing game of Cat and Mouse. It's a little like the Prisoner's Dilemna - if I vote yes, and everyone else votes no, I have just committed Political Suicide.
If you were a Bank in the US, what would you do to try to force the hand of Congress?