Quarterly Newsletter - October 08
Major Indices (as of 23/9/08)
* PE ratios (based on historical
Commentary – Past 3 months
First Quarter 08/09 financial year saw share markets globally continue to suffer led by a renewed surge in US financial woes on the back of the sub-prime crisis dramatically worsening. We saw the collapse of Lehman Brothers, and the takeover/resurrection of Merrill Lynch, Fannie Mae, Freddie Mac, and the world’s largest insurer AIG. Three of Wall Street’s five investment banks have now collapsed. All markets globally declined led by the investment banks.
The sub-prime crisis has substantially worsened and has started to
move into all areas of debt causing chaos in credit markets and a total
loss of investor confidence.
The US still sits on the brink of recession and US financial companies have now written of around 500 billion USD in sub-prime debt, with a possible total ‘at risk’ debt markets exposure thought to be between USD 1 Trillion and 2 Trillion.
This downturn in global equity markets is now seen as the worst since the 1930s Great Depression.
Fears of a global recession are increasing as evidenced by even China dropping their interest rates by 0.27%.
As I write this newsletter Bernanke and Paulson are formulating a plan to buy (take) the approximate USD 1 Trillion of bad loans from the banks.
Oil prices, which had doubled over the past year, took a dramatic decline from a peak of $147 per barrel to fall back below USD 100, somewhat alleviating global inflation concerns.
The best performing sector for the past 3 months again was cash. The worst were financials and commodities.
Currencies over the quarter were summarized by some strengthening in the US dollar possibly on the back of strong US exports and a surprisingly positive quarterly GDP result of 3.2% annualized. The Australian Dollar lost close to 20% as our reserve bank switched stance and dropped rates by 0.25% to 7.0% with talk of further rates decreases to follow in response to the Australian economy’s dramatic cooling. On a more positive note Australia’s finally making some positive trade surpluses to reduce our overall deficit thanks to the mining industry.
The call in last quarter’s newsletter to remain cautious and to keep cash holdings has again proven to be valid.
Oil lead a generalised decline in most commodities as the world has begun to factor in the increasing likelihood of a world slow down and recession (defined as World GDP falling below 2.5%). In particular the Iron Ore spot price has fallen from close to USD 200/tonne to around USD 130/tonne, and copper is down from around $4/pd to $3.22. This is all as a result of concerns over the credit squeeze and the subsequent global slowdown.
This also lead to large falls in soft commodities which had also
had a stellar run the past year and were due for some short term correction.
Commentary – Forecast next 6 months
Again the world markets are delicately poised. On the negative side we have terrible investor sentiment, collapsing US banks, and a global slowdown occurring. On the positive side the US treasury has taken drastic action to free up the credit markets and to remove the bad debt from the banks, which hopefully will see an improvement in the credit markets function and a return of positive investment sentiment. Additionally PE ratios of markets are at decade lows and provided earnings hold up indicate strong value.
I think the most likely outcome is we will continue to see this battle play out for awhile, and provided the credit markets return to function and US house prices stabilize, we should slowly see share markets recover. A key indicator of this recovery will be to watch the credit spreads, the US house prices, the VIX (sentiment gauge) and the US employment numbers. If these indicators start to turn positive then it would be wise to buy more aggressively. However, should economic growth and indicators continue to deteriorate then we are likely to see a US and possibly global recession.
Currently, I feel it is too hard to pick the next 6 months direction
of markets and suggest that investors continue to be cautious and
hedge their bets keeping around a 50% cash weighting.
Finally, if you must invest in the current market invest in companies that can benefit in extremely tough conditions.
What to do?
Continue to be cautious.
NB : Of interesting late news is that Warren Buffet has just decided to take a USD 5 billion stake in Goldman Sachs investment bank. This may suggest we have reached a bottom.
Global House Prices
Looking at the bar chart and graph above should make Aussie residential property investors shudder. Yes, we have negative gearing and a love for property; but after the recent ‘low interest rate baby boomer’ led explosion in Australian property prices it should be obvious to everyone that our prices are headed south.
And yet, most people out there still believe our property prices will keep heading north.
Whilst this sentiment led boom can go on
for some years before a massive correction (look at the Japanese property
crash from 1990
to 2005 as
an example), when it comes it will be nasty.
The US and World’s Debts problems
Put simply, the past decade of cheap credit,(courtesy of Alan Greenspan’s poor work as US Reserve Bank chairman keeping rates at 1% for way too long), has lead to an unprecedented rise in corporate and personal debt levels as everyone borrowed at very low rates and bought up property and shares. This worked fine until recently when rates had risen and asset prices began to fall and over-leveraged and under governed individuals and companies began to default on their debt.
‘Jingle mail’ commenced, where home owners decided to hand back the house keys and default on repayments with no consequences. Hence began a truly ridiculous American practice.
In reality the US consumer has overspent for years and can no longer borrow any more, and in many cases is now in financial difficulties. One in five Americans are said to have negative equity in their home – that is they owe more than the value of their home.
As 70% of US GDP comes from consumer spending it is easy to see why the US economy is in trouble. As US property prices fall further defaults increase, bank write downs increase and more corporate failures occur.
Unfortunately this is all not likely to end until household and corporate balance sheets have purged their debts either by forced selling of assets or gradually by disciplined savings – a new experience for Americans.
It is quite ironic that the US continues to lecture the world whilst having their hands out to the Asian and Oil countries for bail outs.
What is the most disappointing for me is that so many must suffer globally because of the excesses of greedy Americans and terrible US governments that spend billions attempting to be the world’s policeman.
a country the US owes 70% of all world debt and if it wasn’t
for their strong global corporates such as McDonalds, Coke, and Boeing
etc) the US would collapse into bankruptcy.
On the other side, the world is very lucky that the Asian tigers (particularly China and Japan) and the oil nations along with a few other smart countries such as Germany and Canada have spent the last decade accumulating massive surpluses.
Perhaps just like the recent Olympics where China beat the US for the first time, 2008 will go down in history as the year where world power shifted from the West to the East.
Those countries and individuals that have not borrowed recklessly and that have saved (China’s surplus now stands at USD 1.8 Trillion, growing at over $1billion per day), will at last have their glory.
This may not be seen in the short term in their share markets as they are linked by sentiment and companies earnings (currently mostly in decline due to the global slowdown), but will be seen in the currencies.
So, in conclusion perhaps one of the few ways to invest successfully this next year will be by buying Chinese Yuan or Japanese Yen.
The Paulson Rescue Plan
With the US power brokers Paulson, Bernanke and Bush meeting to formulate a plan to restore confidence in the financial markets it is quite likely that this is the turning point in the worst year since 1929.
It is thought the plan will look to take all the sub prime debt and 'toxic assets' from the banks and put them into a Government Fund. Off course this fund may in time be next to worthless causing the US treasury (tax payer) to go further into debt. This is likely to cause US dollars to be printed and hence a diluting and subsequent weakening of the US dollar.
Hopefully US regulations are toughened to stop this from ever occurring again, and the US consumer learns to borrow less.
The lesson Learnt
Whenever you get a herd mentality such as the Tech boom or the recent US sub-prime lending fiasco that causes a bubble in valuations be ready for a spectacular bust afterwards.
You need to look at the underlying asset you buy and understand the risk involved that the asset price could collapse.
On this occasion lenders were prepared to lend to people of no income or assets to secure an extra 1% of margin because they thought they would get away with it – especially as they packaged up the loans and sold on the risk to those silly enough or again greedy enough to want an extra percentage point return on their fixed interest.
The light at the end of the Tunnel
If there is any good news at present, it is that the US at last seems to be addressing their problems and that US house prices having dropped around 20% and are probably about 10% away from fair value.
Based on this, the US economy with a weakened dollar should begin to recover by 2010 and the world economy should be a lot stronger.
As for Australia --- Mmm --- have we heeded the warnings with our own property market? And if not, we may still be dancing when the music stops and face a housing crisis of our own.
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