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"I've seen an elephant fly",
weather forecasts, and why the worst will soon be over
It is almost sad for us that the worst of the world's largest ever
bank crisis is just about to or may even have passed its peak. It was fun
not to hold any and be thought a crazy, even though if any bank director
was asked the right questions, it was clear the system had to fall over.
Now that it has, we move on (but still hold no financials). There are other
aspects we'll miss too. The impotence of Politicians revealed -- no power
to affect the direction of the business cycle, and even less understanding
of the economies over which they portentously believed themselves in
charge. Who will forget the British Chancellor's vacant stare whenever
asked a simple financial question, even as his eyebrows squirmed like
caterpillars in their death throes thus betraying his ignorance?
Then there's the regulators, so far behind the curve it's
embarrassing. No wonder in recent speeches PM Brown announced that he and
the Treasury would sort out the banks, even though the role is split
between the FSA and the Bank of England. We won't miss the shocks after
combing through the balance sheets of Bradford and Bingley, Anglo-Irish,
Northern Rock, RBS, Soc Gen and UBS to discover how weak and sloppy were
their business models; and we look forward to illogical panic reactions
ending. For in the midst of the largest financial fire in history, more
effort has been expended on arguing who is to blame, rather than trying to
find the extinguishers. Happy, happy days. Farewell.
If you do not weep uncontrollably whilst watching Dumbo (the movie,
not the people above), then you have no soul. The climax of the story is
that without his white feather he could not fly, and was but a terrified
and rather badly drawn pachyderm at the top of the high dive. With a little
persuasion however, he realised the lack of his comfort blanket did not
preclude him from his destiny, so off he flew. The multiple financial
implosions of September and early October reduced governments, central
banks and regulators into a Dumboesque, catatonic inertia. Fortunately, the
panic in all markets has made them realise that they did have sufficient
powers: if not to fly, then at least to prevent an immediate Depression.
Thus for the first time this century, there is good clarity on the medium
term future, both for the global economy and stock markets. This is one of
a steep recession, followed by several years of a mild and stuttering
recovery. Surprisingly, this is a good result.
The eye of the
storm has just passed over
As long ago as 1999, a long and thoughtful front page article in the New
York Times highlighted the dangers of the world's two largest mortgage
underwriters, Fannie Mae and Freddie Mac. They had just been blessed by the
regulators, Congress and President Clinton to tear up the risk book: to
offer large and easy mortgage terms to those Americans who could never
realistically hope to own a home. This relaxation of prudent lending rules
was soon widely imitated, particularly in economies with a property owning
mentality. The consequence was a global economic growth chimera,
accelerated by the reduction of the dead hand of bureaucracy in third world
countries such China and India. This allowed them to achieve far better
growth rates.
From 1999 onwards the hurricane started to build, moving ever closer to
the world's financial system, obvious even to the man in the street. Yet
the near-term gains were so beneficial to individuals and government
budgets that every Finance Minister threw prudence down the well.
Chancellors even became popular. Bizarrely, the only people who did not
recognise the inevitable were the regulators, senior bankers and fund
managers. In 2007, the storm ripped into the banks. There was a brief calm
as the eye came overhead, within which complete regulatory and political
paralysis developed, even as institution after institution imploded. Now
the eye is passing; we're back into the other side of the storm. Initially
the winds will be extreme, but each crisis will be a little less than the
one before. It is the best possible outcome, for the alternative was an
immediate vertical drop into a deep economic Depression. This would have
made the 1930s look a picnic. The 'positive' alternative may not seem that
glamorous as many small countries are already in recession and the major
ones will follow before the end of this year. Yet this recession will be a
45 degree slope, not a 90 degree fall. This is because the correct response
is now in train. It means that as early as 2010, a stuttering recovery
could commence.
The British
solution goes global?
It is a great surprise that three small islands off North Western Europe
have been the cause, and the cure, of the crisis. It was Ireland's emergency
guarantee of all deposits which set off the nuclear reaction: risible,
because its blanket nature covering all deposits for its six banks worked
out at $576bn, nearly three times gross domestic product, $130,000 per head
or $200,000 per person in employment. Within these numbers was a
sub-liability of nearly $50,000 per head over foreign deposits, mostly
British. Despite now excellent Anglo-Irish relations, if these guarantees
had been called, they could never have been paid. Immediately Germany, Spain,
Greece and smaller countries followed suit. Mildly anti-EU British
politicians then peculiarly started to bleat about supra-national solutions
- an impossible dream - and did nothing. More sensible foreign leaders
reacted nationally to the inevitable consequences of their electorates
seeing their local banks disappear in a puff of smoke. Fortunately, market
mechanisms then kicked in. Large British deposits were being sucked out,
into unreal Irish bank guarantees at an alarming rate. Meanwhile in Iceland,
the third offshore island, the entire bank system finally decided to die.
Although this was assured much earlier (see Pick of the Week No. 48,
"Abdul and Jorvik Go Shopping"), it had staggered on for a
surprisingly long time. The twin Irish/Iceland events resulted in dramatic
falls in British asset prices and even worse gridlock in the lending
markets. Outflows to Ireland were swiftly followed by a sudden realisation
that simply idiotic deposits worth over £5bn had been placed into hopeless
Icelandic-owned institutions and were about to disappear. Depositors
included over 100 UK local government authorities as well as unwise
financial intermediaries. Without warning and in a single bound, the
British governing class leapt from narcolepsy to sprinting at gold medal
speed.
The key change has been the rapid implementation of the most
comprehensive bank bail out package ever seen. It should work, because it
addresses the overlapping problems of too little Tier 1 capital, the fear
of bank counterparty risk, the inability to roll over corporate loans and
the risk of deposit flight. The result is state directed capitalism. It has
lead to howls of outrage across the investment and political spectrum, from
the purists who believe market forces should be allowed to work themselves
out, to the mob baying for capitalist blood. The cacophony of noise and
finger pointing will continue for many years, but both arguments are
irrelevant. They are based on old rules. For just as in war habeas corpus
and other rights are torn up, so in a financial meltdown the old rules are
shredded.
The British decision has been to save the core of the national banking
system and create a more realistic structure than the blanket guarantees of
Ireland. The sums pledged are large enough to meet all the capital required
to support the capital of each major domestic bank. The use of high
yielding preference shares and permanent income bearing securities is
likely to mean the government may end up owning perhaps a mere quarter of
three to six banks, yet its ability to control them all, and their lending,
is a certainty. This multiple approach is already being favourably viewed
in other countries; it is speedy, cheaper and turns the all-important
psychology from one of utter despair to merely gloom. It is more effective,
and overall less burdensome on the taxpayer than any other solution. In the
UK and elsewhere, the previous drip feed of liquidity into the markets,
started by Mr Paulson in the US, simply proved the law of diminishing
returns. Ever larger funds had to be provided to produce ever weaker
results. To be fair, the unique (so far) British solution is almost the
same as Mr. Buffet's bail-out of Goldman Sachs. His very high yielding
preference stock and presumably many other strings must have provided a
guide.
Britain's Treasury mandarins had also dusted off and absorbed the
lessons of earlier French, Swedish and Japanese models. The result is a
more effective hybrid. Since President Mitterand nationalised the banks in
1980 (later part re-listed), France has had state directed capitalism
dominated by three banks. Inevitably these are ponderous and suffer poor
shareholder returns, but in a whacky way, the system works. In Sweden, the
necessary nationalisation of anything with 'bank' on its nameplate also
proved effective; although the stock market did not recover for 18 months,
the economy managed weak growth in almost every quarter. Japan's Resolution
Trust Corporation initially failed because the government dithered for six
years after the 1990 crash, before taking any meaningful action.
Subsequently, vast amounts of debt were issued to hoover up bankrupt banks
and duff corporate loans. It worked. We believe that most G7 (i.e.
including America) and G20 countries will adopt Britain's hybrid ruse in
the near future; if so, the storm is passing for sure.
Foreseeable
consequences
Some are most unpleasant. The authorities will have little control over
these and it would be foolish if they seek to cover every eventuality.
Staying with our three islands, one result is that Britain has probably
exacerbated the Irish banking crisis; the depositors who fled there for
"safety" will soon work out they are better off and better
covered in government controlled banks back home. As the new UK rules bite,
runs on some mutual groups such as building societies or Spain's
equivalent, the Caixas are likely; in both cases their prime purpose is to
take deposits to fund property purchases. Government guarantees do not and
cannot extend to such groups. Banks like Santander will be forced to absorb
dozens of these local mutuals, as will Commerzbank in Germany. This trend
is extant already with the large banks in America. Most major industrial
countries therefore will end up with a handful of large semi state banks
which will dominate the domestic deposit markets.
Other casualties may include leasing companies. With no deposit base,
often no overall regulator and dependence on wholesale funding, their
future is not exactly bright. More casualties abound in Eastern Europe;
many countries there needed to devalue even before the storm hit. Now
devaluations are imminent. Elsewhere, several larger countries will have
their own particular problems. One we fear for is Australia, ironically
because of a very good policy. After Singapore and Chile, it has one of the
most logical and best funded pension schemes in the world (curiously, this
is a legacy of its most socialist Prime Minister, Gough Whitlam; even more
curious, he was 'deposed' by the British High Commissioner and Mr Rupert
Murdoch in 1975). The scheme is beautiful in its simplicity. From the first
day at work, employees and employers put large percentages of salary until
retirement into a personal, untouchable pension pot. Tax-free and
ring-fenced, these huge flows are managed by a host of competitive and
usually efficient 'Superfund' managers. Of all reasonably sized advanced
countries, Australia alone has ensured that an ageing population will be
able to fund itself without drawing down from the state. Yet a flaw has
developed. The industry is competitive, Australians are ruggedly
entrepreneurial. Personal pensions are portable at the push of a button.
Recently, some Superfund valuations have been exuberant. Many have as much
as a third of investments in unlisted property, private equity and other
opaque vehicles. Often performance seems remarkable: to June 2008 perhaps
+20% in a year, usually based on internal valuations. Yet similar
investments listed on the public markets have seen large falls in value. It
unlikely there's much, if any, fraud, merely denial and over-optimism.
Given Australians are well-educated and financially literate, it seems only
a matter of time before some awake and transfer their pensions from the
optimistically priced super funds and switch to those whose prices are more
realistic, and low. It is the smart thing to do. If there is one lesson
from the crisis, it is 'if there can be a run, there will be one'.
Another country is Italy. It seems to think itself relatively safe.
Italians (and most Europeans) have shown a hubris over financial implosions
in America. It is worth recalling that in absolute terms, and pro rata to
national GDPs, European institutions own more of America's mistructured and
bankrupt sub-prime debt than the Americans themselves. Where is it? Too
much we believe in Italy. There, opaque bank balance sheets make Japan's
look as clear as glass. The industry is fractured. Like Iceland (but to a
far lesser extent), there are considerable cross holdings, mystery nominee
companies and asset shuffling by feisty entrepreneurs. These in turn are
often highly geared, with a maze of cross-holding debt structures. When the
giant hornet of the recession flies into this web, it will simply it snap.
Embrace the
recession
A global Depression is likely to be avoided by a whisker; a fast and
vicious recession now is a certainty. Although key forecasts are being
revised lower, they still lag this outlook. The IMF's latest suggestion
that China will grow next year by 9.6%, and that the volume of World trade
by 4% are but two examples of excess optimism. China will enter a
recession, defined as 4-6% growth. At this level, social unrest tends to
accelerate. The collapse in commodity imports, from copper to steel, show a
slowdown already under way. Another obvious cause is the once insatiable
appetite of American consumers, to import at least five toasters and three
refrigerators for each home has already ceased. As regards growth in world
trade, the 4% forecast is also optimistic, given demand for bulk
commodities, such as oil and iron ore, is tumbling.
Consumer incomes will be squeezed until the pips squeak, because of
correct government actions to focus only on saving the major banks.
National budgets are blowing up into huge deficits. The idea that America,
the world's most important economy, is sure to have a budget deficit of 10%
of GDP in 2008/9 is simply eye-popping, as is the 40% increase in the last
six months in the public sector borrowing requirement in the UK. To finance
these giant deficits, governments will have to tax more and spend less.
Just as the bank rule book has been torn up, so the global abattoir is
hardly large enough to slaughter the queue of sacred cows. In Britain, the
burgeoning black hole in of state sector pension funds will have to be
minced. Apart from the fact that many have been mismanaged for years (their
leap into Icelandic deposits because they were approved by discredited
rating agencies, or their belief that the higher the deposit rate, the
better the bank, prove the statement), their over-generous terms are now
unaffordable. Whether the government achieves this through a wholesale rise
in the retirement age, increased taxation on pensions, or a cap on the
payout rate like utilities to RPI minus, is a moot point. Another chopper
must be taken by all governments to welfare.
Although welfare abuse is rampant across Europe, statistically it is
worst in British and is both unaffordable and wasteful. As we have reported
before, false unemployment statistics have dominated the last decade.
Unemployment sank from well over two million to under a million. Meanwhile,
those of working age but permanently incapacitated soared from under a
million to well over two million. Cute trick. So Britons are the puniest
people on the planet, according to officialdom. Aggressive steps will have
to be taken to prune the number, if only because of the certainty that
unemployment will rise, thus busting the budget even further. State
directed capitalism must emerge with heavier-handed, state monitoring of
its population.
Whilst liquidity and lending will gradually improve, governments will
want to rebuild 'their' banks' balance sheets as fast as possible.
Globally, official interest rates will be slashed; the unusually
co-ordinated cuts earlier this week by six major central banks is but the
start. Lending rates however, will stay high thus increasing the margin
between deposit rates and the price of loans. Fees will also soar, such as
new extra charges in most economies for arranging a mortgage. Many did not
exist at all even a year ago. Credit card companies will lower credit
limits to individuals, irrespective of true personal wealth, as their
imperative has switched from maximising profits to minimising losses. Only
the best personal balance sheets will get decent-sized limits. If
individuals cannot obtain credit, they are forced to save if they want to
buy a new car, or a home. In the 1970s and early 1990s recessions, savings
rates in advanced countries rose dramatically: in Britain from 2% to 12%,
in America a slightly smaller rise. 12% again seems a good educated guess,
especially as the starting point is record low savings rates (-1.1% in the
UK for the first quarter). Thus the impact on retail economic activity is
dire. As governments tax more and cut expenditure, and the consumer is
forced to save, this is why for 2009 we pencil in at least two quarters of
serious GDP contraction for the UK, US, Spain, Australia, Ireland and
Italy.
Unforeseen
consequences
We did not expect that within two weeks of a financial meltdown, Russia
would have achieved a key military ambition. As four Scandinavian
governments dithered over supporting their fifth cousin a window opened, in
through which Putin flew like Count Dracula, with a $4bn lifeline to
Iceland's government: "no strings attached". Oh yes? Russia in
Europe has always been "choked". The Black Sea/Bosporus ext is
tricky. Large naval vessels can leave Petersburg but the Baltic straights
too, are narrow. Hence much of the fleet is in the only other port,
Murmansk. Even from there, the problem has been that to get the navy into
the North Atlantic, it is blocked by other straits such as the English
Channel. In 2005/6, NATO schizophrenically decided to poke Russia in the
eye by putting missiles along its European border, and also to close its
Keflavik Airbase in Iceland (although there are still a few odd American
planes there). It has handed Russia at worst a neutral sea passage, almost
certainly a refuelling base/friendship zone. This makes us slightly dither
about defence stocks. They look cheap but historically in recessions,
governments have slashed military expenditure. The UK could cut back its
still quasi-imperial ambitions and become a Belgian-type power. Even so,
across all Western Europe, so antiquated are many armaments and so poorly
equipped many of the troops, it may be that defence, usually the first cow
to the slaughter is actually fattened up instead.
America too has usually slashed defence budgets in previous recessions,
and could do so now. Any one of the 14 battle fleets has more fire power
than the entire Chinese navy. The totality of America's naval firepower is
nearly 60% of the entire world's navies combined; such overwhelming
superiority is unnecessary in terms economic expenditure or national
security. Yet operating in two oceans, with Russia sending off a fleet to
Venezuela in one (we're amazed the rust buckets got there at all) and a
Chinese naval building programme which is accelerating, we suspect
America's military will continue to claim its full funding. So too wills
NASA: rocket launches already planned from Asia will allow more communist
cadres to peer down at Houston from space than ever before. This is not
going to be popular.
This is
cheerful?
For all these imponderables and uncertainties, investors can start to do
that 'light at the end of the tunnel' thing. If the hurricane had hit in
2005 or 6, the damage would have been less; but this is spilt milk, move
on. The light is that correct actions are now in train. Many savers will
still lose money in those weaker institutions which the governments have
rightly decided to sacrifice, to preserve the core of the system. It will
be unfair and unpleasant, but the right action. More important is that just
as banks in each country will consolidate down to a core handful, so the
same will apply in many other sectors. Consolidation is the new trend.
Normally the advice would be to buy small bombed-out niche companies with
good businesses, knowing that giant multi-nationals, most of whom have
surprisingly strong balance sheets, will be buyers. However, the number of
already wounded, as their banks reduce or refuse to roll over their loans
at all, mean these multi-nationals can be very picky, and wait. Just as
government-induced bank consolidation ensures their balance sheets should
recover far faster than had there been no intervention, so more voluntary
consolidation in other sectors will have a similar result. Consider the
semi-conductor industry (if only for a moment). It is about to be
obliterated. Huge over-capacity and rapidly tumbling demand. By as soon as
end 2009, it is a good bet the number of manufacturers will have halved.
Their profit cycle will then boom. Consolidation in pharmaceuticals has
already started, one of the few sectors with very strong free cash flow and
growth. In telephony, the parasitic companies are about to be sprayed with
DDT. These lived off the incompetence of once state owned incumbents to
move into the mobile market and almost universally, are highly borrowed,
rely on ever-available bank credit and ever-rising sales. The consumer
always foregoes trips to the cinema or theatre in a recession. This time he
will hunker down in front of his broadband-fed, all singing and all da
ncing pc/TV/call-centre/work station. Only the ex-national monopolies can
proved this service, the rest blow away like chaff.
Despite consensus forecasts for corporate profits in 2009 being still
way too happy -- we are pencilling profits ex the banks for the MSCI World
Index in 2009 of minus 9% - the return to an almost forgotten world of
national and international cartels to reboot the economic cycle may well
ensure that after a steep recession, a return to mild profit growth may be
none too far away. The 'death' of free markets is sad: for a while we were
all rich, it was fun and you didn't have to work much either; just own a
house and a lot of debt. The imminent brave new world of state directed
banks and cartelisation of sectors is inherently corrupt and less efficient,
but should work. It is certainly the least bad solution for us all; yet
this very different and cartelised world could be rather interesting, and
profitable. Although indices have every chance of a roaring bounce soon, in
2009 many will sink again. Even so, too many large company valuations are
already forecasting a Depression. We think state owned banks are
temporarily rather a good idea, and many company valuations look pretty
interesting, especially versus bonds, property or even cash. Growing huge
ears or sticking a white feather up your nose is another option, but not
advised. |
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