Flash ReportAs we write Viewpoint September 2008, there is a continuation into October of the significant market stresses that were notable last month. The major of these concerns continues to be the financial sector and the fears that further weakness and illiquidity of the financial sector could have serious repercussions for the rest of the economy. These risks are clearly being taken seriously by central banks and governments across the globe. And so it should be: so far in October there have been significant losses from the equity markets and also most other risk assets. A continuation of the flight to quality, combined with a dovish interest rate outlook has pushed US 10 year Treasury bond yields down to as low as 3.5% in October and a concerted effort from central banks globally to cut interest rates to increase the liquidity in the system has given further impetus to bond prices. Credit, however, has continued to sell off and yields are at all time highs in a number of sectors. Since the collapse of Lehman in September, the rescue of AIG, the purchase of Merrill Lynch by Bank of America and the purchase of Wachovia by Wells Fargo, there have been continued concerns in the banking sector. Rumours abound as to whether Morgan Stanley and Merrill Lynch were adequately stable, and as a result of the uncertainty, the former has sold 21% to Bank Mitsubishi UFJ for USD9 billion in preference capital. Moves such as this, the US’s Troubled Asset Relief Program (TARP) and the European recapitalisation effort have actually provided some stability to a global equity market that had experienced its greatest ever one week loss up to 10 October. Hank Paulson’s TARP in the US enjoyed a faltering trip through Congress to approval and this did not fill the market with confidence. Although politically it may be smart to not appear to be ‘bailing out banking fat cats’ at the expense of the tax payer, the debate amongst politicians and even members of the Federal Reserve has given the impression of something of a power vacuum in the post-Greenspan era. The UK, in fact, appeared to act in the most effective way by emulating the Swedish government in their early 1990s banking crisis. It has now emerged that this plan was to invest nearly GBP40 billion into a number of major UK banks in order to improve their capital ratios. This effort has, in concert with further loosening of central banks’ lending criteria and interest rate cuts globally, caused some stability. Whether this turns into a sustained progression for risk assets is still very much open to doubt. It is clear that this new capital will come with strings attached and investors in financials may feel relieved, but not necessarily optimistic. Sweden provides a lesson in how government capital into ailing banks can provide a profit to the taxpayer over time, but not all Nordic countries should be looked on as a benchmark. Iceland has in effect seen the collapse of all its major banks this month. This economy was heavily reliant on the financial sector, and these recent moves have caused considerable stress to the economy. Other notable stumbles came from Fortis, a large European banking institution, which had to be stabilised by three European governments before being effectively bought by BNP Paribas. More recently the Dutch bank ING received EUR10 billion from the Dutch government. Despite the capital injection this class of equity capital is essentially a free allocation to the Tier One capital of the bank. The Dutch tax payer’s equity is non-voting and the capital is non-diluting for existing share holders. Overall it appears that the market is now less wary of the financial sector but more concerned regarding a widespread global slowdown or recession. Some glimmers of hope can be seen from a fall in LIBOR from its very high levels, as well as seemingly more active interventions from central banks and governments across the globe. The latest deal, involving ING, appears to reflect a greater understanding of the shareholders’ concerns, but the lack of control for the government means that this model is unlikely to become the norm. Let us now turn our attention to September. As we noted in the preface to the August edition of Viewpoint, the bankruptcy of Lehman Brothers sent shockwaves across the globe. The consternation that this caused was exacerbated by the rescue of AIG, only days later, by a USD85 billion loan for 79.9% of their equity. This loan from the Treasury was undoubtedly required, but hardly a gift given the rate of LIBOR plus 850 basis points. Later in the month investors saw the end of an era as the last two remaining major investment banks, Goldman Sachs and Morgan Stanley applied to become deposit taking institutions. This should have two major benefits for these organisations. The first is that as they will now hold investor deposits, they are unlikely to be as geared going forwards. Secondly, banks, as opposed to investment banks, can go to the Federal Reserve’s loan window and borrow funds from the US taxpayer. The volatility present in all markets in September increased markedly from already high levels reflecting increased levels of both uncertainty and concern as a number of major financial institutions appeared to move close to the brink of bankruptcy. Let us now turn our attention to September. As we noted in the preface to the August edition of Viewpoint, the bankruptcy of Lehman Brothers sent shockwaves across the globe. The consternation that this caused was exacerbated by the rescue of AIG, only days later, by a USD85 billion loan for 79.9% of their equity. This loan from the Treasury was undoubtedly required, but hardly a gift given the rate of LIBOR plus 850 basis points. Later in the month investors saw the end of an era as the last two remaining major investment banks, Goldman Sachs and Morgan Stanley applied to become deposit taking institutions. This should have two major benefits for these organisations. The first is that as they will now hold investor deposits, they are unlikely to be as geared going forwards. Secondly, banks, as opposed to investment banks, can go to the Federal Reserve’s loan window and borrow funds from the US taxpayer. The volatility present in all markets in September increased markedly from already high levels reflecting increased levels of both uncertainty and concern as a number of major financial institutions appeared to move close to the brink of bankruptcy. Given the above, investors had little hope of a good month for equities. That was indeed the case, as the MSCI World Index returned -11.9% in US Dollar terms. In September there was a moderate continuation of Dollar strength, meaning that reporting global returns in US Dollars provides a slight headwind to performance. The US equity market returned -9.0% which, although poor from an absolute perspective, was a reasonable return, given the performance of some other regions. Europe and the UK both returned -15.2% in US Dollar terms and Japan returned -10.7% in US Dollars, helped to an extent by a strengthening Yen. This sell-off was broadly based, but interestingly the financials sector’s return of -8.6% globally actually outperformed other sectors such as Energy (-15.4%) and Materials (-24.1%). Overall the equity markets reflected a flight to quality on the part of investors and the returns from materials and energy suggest an increased chance of a prolonged period of slow growth or possibly recession. Emerging markets equities also suffered as a result of increasing investor anxieties regarding risk assets, returning -17.5%. Notable performers in US Dollar terms included Brazil, returning -23.1% in a month and Russia, which returned -26.1%, in a difficult month for emerging market equities. In September the flight to quality benefitted the global government bond market. Global government bonds generated a small positive return in local currency terms of 0.3%. This suggests that despite the continued buy-side pressure, there is not a great degree of room for a continuation of the reduction in yields. Due to the strength of the greenback, the index was in negative territory in US Dollar terms, returning -1.2%. This contributed to the investment grade bond indices, but failed to prevent a slide into slightly negative territory as sell-side pressures affected credit. Interestingly, although the US government’s debt may be the closest thing to ‘default proof’, the magnitude of the facilities provided to the likes of AIG have led to some increased investor doubt over the creditworthiness of the US. This risk, however, is still very small as evidenced by the credit default swap (insurance that pays out in the event of bankruptcy). High yield bond spreads widened as investors reappraised the amount of yield that they were willing to accept for holding this credit risk. As a result of the spread widening by about 270 basis points, the index returned -8.9%. This return is below investment grade debt and this is to be expected at times of risk aversion. Recently we have been advocating that investors stay underweight equities and seek other means through which to access risk assets. We believe that high yield bonds provide an interesting opportunity for investors at present. In September the high yield index outperformed global equities. We believe that the presence of a running yield in the order of 14% on average for the index provides a degree of protection to the total return of these assets when compared to equities. Despite a number of recent poor months as investors turned increasingly bearish on the outlook on the global property markets, in September the global property markets outperformed the global equity market, returning -9.3% in US Dollar terms. This is still a poor return, but it is relieving to see property finally performing in a manner that is more defensive than equities. This may suggest that investors perceive property, as a result of its large falls over the past year, to be closer to fair value than the rest of the equity market, whilst the rental income provides a floor to valuations. The regional performance differentials were again present in the property universe, with investors being clearly most bearish on Asian property. US Property provided the strongest returns of -0.1% in US Dollar terms, whilst the UK returned -7.3%. Europe proved to be less defensive, returning -13.8%, but Asia lagged this, returning -17.7 % in US Dollar terms. Recently we have noted that the US property markets led global property markets down, followed by the UK. We also suggested that this might mean that these regions may be the first to bottom. In Asia and Europe a combination of continuing questions about the medium-term economic outlook may weigh on property prices further still. As mentioned above, the US Dollar has been a beneficiary of the recent increased market uncertainty. The Yen has also performed well this month. This is due to a combination of reasonable economic fundamentals, combined with conservative company management over the last decade, in addition to an increasingly less disadvantageous interest rate differential as other economies cut their interest rates. One final contributor to yen strength may be the continued unwind of carry trades. Last year investors who borrowed cash in yen and then invested the proceeds in higher yielding securities in economies such as Australia and New Zealand could enjoy a reasonable profit. These proceeds available as a result of the interest rate differential, although reasonably appealing, were always at the mercy of rapid currency moves. In these times of greater market uncertainty, investors who still had these positions open are unwinding them. The result of this is an increase in yen purchases to repay the yen denominated loans. Yen gained 2.2% against the Dollar, whereas Sterling and the euro both depreciated, returning -2.3% and -4.6% respectively.
Source: Bloomberg, October 2008.
Ad hoc liquidityThe first response to the stalling of the money markets was for central banks and government treasuries to attempt to improve the liquidity in the market. These institutions can take financial assets as collateral for loans that they make to banks. As the financial companies struggled to raise short term financing from each other, an obvious first step attempt at providing stability was to provide this financing from the central bank. The central banks insisted that a certain quality of financial asset left as collateral be used, although they became less discerning as the efficacy of this method dropped off. A second means of pushing liquidity into the system was for central banks to cut interest rates. The rationale behind this is that as banks can borrow at a lower rate from the central banks, these cost savings will be passed onto the interbank market. This method is traditionally effective, however these attempts at stimulating the banking system were largely ineffective. Furthermore, as the worries in the interbank market grew, the spread between LIBOR and the base rate in the US actually moved in opposite directions (see Fig. 3). The message was clear: despite the Fed's actions, the lending banks were still too nervous about their counterparts' solvency. Furthermore, any bank that had some cash on its balance sheet would rather hold onto it in an attempt to boost its internal capital ratios than put it to work in the money market. One final problem that the interest rate cutting method faced was that of inflation. Although this has largely fallen from most investors' list of core concerns, the inflation risk in the UK and Europe, for example, was adequate to stop any serious slashes in interest rates. The ECB and the Bank of England both have inflation targeted mandates, adherence to which precluded aggressive rate cuts. TARPThe US Treasury, led by Hank Paulson, attempted a second method to reduce the anxiety in the interbank market: the 'Troubled Assets Relief Program' (TARP). The programme is run by the Treasury's newly created Office of Financial Stability. TARP enjoyed a stumbling and timid gestation and did little to reaffirm faith in Paulson or Bernanke following the Lehman Brothers debacle. The Treasury may use the fund to buy a multitude of loans "for which there is no current market". On the face of it this would address many areas of bank balance sheets which equity holders would prefer were not there, however there are a number of elements of TARP that are still yet to be decided, not least how to price assets. This apparent paralysis of this method may be due to the fact that TARP has become somewhat superseded. It would now appear that the US government is beginning to recognise that buying up USD700 billion of 'toxic' assets will not solve the credit crisis or restore financial and economic stability. It will simply shift toxic risk to taxpayers. As a result, TARP, whilst removing these undesirable assets off the balance sheet and giving banks cash in return has been criticised for failing to boost liquidity beyond this first step. Ultimately, there are two concerns regarding TARP. If the Treasury buys toxic assets at real market prices, banks will face further write-downs, which will continue to impact their capital ratios. If, however, the Treasury buys bad assets at inflated prices, the taxpayer bears significant risk, and there are other ethical questions related to buying bad assets at above market prices. RecapitalisationCritics of TARP suggest that stabilisation of the financial system required significant recapitalisation of financial institutions. Up to this point central banks have tried to inject liquidity by cutting rates, expanding access to discount windows and creating new funding programmes, but the flow of credit has been interrupted because the intermediation system is broken. Financial institutions have come to the market already this year and some of the issues were greeted with (contained) enthusiasm. However, the nervousness around these investments has increased, augmented by the fact that those who bought the Bradford and Bingley rights issue in July 2008 at 55p per share, lost all of it. Short of significant interest from Asian or Middle Eastern wealth funds, banks are unable to raise anywhere near the necessary amount of equity in the market. With debt being so expensive and unavailable at the moment, the only realistic source of equity capital is the domestic governments. The most recent historical precedent for this is the Scandinavian banking crisis, where equity investments made at a time of crisis actually turned a healthy profit for taxpayers. Perhaps surprisingly, given the earlier chaotic approach to Northern Rock and regular leaks from the Treasury, the UK actually seems to be leading the way out of the immediate risk to the financial sector. The UK is to invest up to GBP37 billion and Europe looks set to follow this lead. The motivation behind this move is to prevent the capital ratios of the banks deteriorating further than their present levels. This should provide a degree of stability as confidence returns that banks can repay any short term debt that they assume between each other. So far into October, this final push by the governments and regulators appears to have found traction and the financials sector is no longer the most maligned in the index. That is not to say that the markets are engaged in a strong relief rally. There are a number of issues that investors have to come to terms with. The first are the number of conditions that are attached to the equity injections into the banks. A number of different requirements including the cancellation of bonuses and dividends have been mooted and this is concerning investors. Also the fact that there has been a part-nationalisation of these institutions would worry those of a purist capitalist persuasion. A final issue for equity investors at present is the fact that although the banking sector may have been saved, it will go forward as a distinctly different beast. Government equity holders will not want these to be such risky businesses, rather the 'public service' of deposit taking and providing a conduit for payment and borrowing will become key. The positive to take from this is the fact that the banking sector has not imploded and this provides a solid base off which the economy can look to stabilise and then grow into the next cycle. Source: Bloomberg, October 2008
Important NotesDisclaimer:
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The commodity markets sold off again in September as investors reviewed their anticipated global economic growth downwards. Lower growth levels will reduce the demand for raw materials for both construction and infrastructure as well as for consumer goods. In addition, if the much vaunted burgeoning middle classes emerge in the developing world in a slower manner, this should also result in a less imbalanced supply and demand relationship in the medium term for both hard and soft commodities. The direct result of these falling commodities prices has been to reduce inflationary pressures in the global economy and the reduced demand can be seen in the falls in the reduction in the cost of shipping (see Fig. 1). The benefits of the reduced likelihood of inflation are several fold, but the key result is that the global economies are less likely to turn stagflationary. Global growth will likely slow in the medium term as the fallout of the credit crunch continues, but if this is not combined with inflation, central banks will have more room to cut interest rates to provide some growth stimulus. This is especially the case in areas such as the UK and Europe, where the central banks have inflation-targeting mandates. In September, Agriculture returned -14.8% and broader commodities performed similarly, returning
-13.5%. Oil fell -15.8%, but gold was a notable exception, benefitting from its status as something of a safe haven for investors, returning 6.2%. |
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