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