I RECEIVED a few queries from readers of my last article in BT (’Deciphering the message of the markets’, Aug 1), which discussed, among other things, the origins of the recent sharp market retrenchment. There were two main issues:
1. The graphics were unfortunately left out of the published column. Here they are. The five-day chart demonstrates the tight correlation between the fall in European markets and the strength of the yen as hedge funds and Mrs Watanabe (Japanese housewives) got unwound by margin calls.
2. Was I opining that the fall in markets was an investment opportunity? My apologies about being insufficiently explicit. Yes, the answer is that it was a buying opportunity.
Indeed, I believe this is still an investment opportunity although the sub-prime problem has morphed into a more general credit crunch problem arising from the loss of confidence within the global financial system.
Due to the lack of transparency, it is difficult for each bank to determine what sub-prime debt exposure their banking counterparts have. Although much of the sub-prime mortgages have been replicated as bonds and sold off to investors worldwide, banks have off-balance-sheet liabilities in the form of ‘conduits’, etc, where borrowers (who hold these bonds backed by sub-prime mortgages) could draw on lines of credit with these bonds as collateral.
Central banks around the world have generally managed this fiasco fairly well. There is no loss of confidence amongst depositors except in the UK, where Northern Rock unnecessarily suffered the ignominy of a bank run.
The confidence of depositors is not misplaced. Most of the world operates a system of fiat money with central banks (who control the monetary printing press) being lenders of last resort. Any problem which can be solved by ‘printing’ money is in principle a straightforward one for central banks to deal with.
The individual exposures may be hard to ascertain but things look different from a system perspective. Here’s my quick analysis:
Combined profit of all listed banks and insurers at US$1.1 trillion.
Total sub-prime debt at US$0.6 trillion.
Assuming a write-down of 30 per cent of collateral value, loss at US$0.18 trillion. This would be a one-off loss equal to only about two months of profits of all listed banks and insurers.
Yet, the loss of market capitalisation at the market nadir was US$1.5 trillion for global financials and US$4 trillion (more than 20 times the projected loss on sub-prime debt) for the global equity markets.
Does the market reaction make rational sense? Nonetheless, the dislocation in the capital markets has had an impact on business confidence surveys globally. The imponderable is, as always, the contagion effects. How does this affect the wider economy? Exact quantification is difficult. It is not only uncertainties with the economic modelling; policy response also plays a significant role in the outcome.
Fight or flight?
To get a measure of our ‘fear factor’, I did another quick analysis. This time I used the most recent economic cataclysm: the Telecom-Media-Technology (TMT) bust of 2000 to 2003. Capex spending was running far in excess of GDP growth. It is estimated that the overinvestment in capex leading to 2000 globally was (cumulatively) circa 10 per cent of global GDP, or US$2.5 trillion.
This eventually led to write-offs and bankruptcies on a massive scale. The subsequent impact on global GDP is estimated to be (cumulatively) about minus-6 per cent. See demonstrative charts (above), which were sourced from Moody’s Economy.com - the horizontal dash line marks the level of trend GDP growth in the US and the euro zone.
The impact of this sub-prime fiasco appears tolerable as the drag on global GDP is expected be in the region of 0.5 per cent. Ironically, this could be the enforced rest that the global economy requires in order to keep inflation at bay.
Indeed, the rise in money supply from rate cuts combined with reduced demand from the real economy could expand equity PERs over the next few months as excess money supply rises. Fundamentally, the S&P Global 100 Index trades at about 13.1 times, trailing earnings (about 12.1 times one-year forward earnings), which is compelling relative to long-term fixed income yields. For example, 10-year USTs are trading at a yield of 4.6 per cent.
The writer is CEO of financial adviser New Independent.