Bernanke Goes Forth

“Edmund: You see, Baldrick, in order to prevent war in Europe, two superblocs developed: us, the French and the Russians on one side, and the Germans and Austro-Hungary on the other. The idea was to have two vast opposing armies, each acting as the other’s deterrent. That way, there could never be a war.

Baldrick: But this is a sort of a war, isn’t it, sir ?

Edmund: Yes, that’s right. You see, there was a tiny flaw in the plan.

George: What was that, sir ?

Edmund: It was bollocks.”

- From ‘Blackadder Goes Forth’ - Richard Curtis and Ben Elton.

So the Federal Reserve has shown it is willing to act as a prime broker (to the tune of another $200 billion) even if the rest of Wall Street is having second thoughts about the role. This week’s immediate response to another historic liquidity injection was an unsurprising relief rally by stock markets, but the longer term reaction will be an equally unsurprising retreat back to the lows. Stock market investors seem to be thinking, “If easy money got us into this mess, surely even more easy money will get us out.” Replace ‘easy money’ with ‘idiocy’ or ‘leverage’ and you can see the essential logical weakness of the proposition. Diapason’s Sean Corrigan was not alone in wondering whether the Fed would be getting value for money from its latest liquidity experiment:

“According to my reckoning.. the Fed’s extra $253 billion in liquidity enhancing measures bought a 1.3% increase in the S&P 500. Since we need a 19.4% rally to regain October’s Sucker’s High at 1476, we might only need another $4.8 trillion in new measures to do the trick ! Neatly, that would equate to the Fed buying out the outstanding total of Agency / GSE-backed mortgage pools, with enough room to nationalize Freddie and Fannie at current market value, into the bargain. Over to you, Ben..”

Unfortunately, there is just one tiny flaw, cf. Blackadder, in Bernanke’s plan. Not least, a crisis of solvency will not be resolved by the provision of any amount of liquidity. As Marcus Ashworth of Mitsubishi UFJ points out, the latest emergency measure “probably only postpones the latest series of fire sales, allowing some to meet margin calls and hang grimly on pro tem, but it does not recapitalise the financial system. In fact, it helps banks to own [impaired debt] for longer,” and it merely delays what must inevitably come – the transfer of toxic waste to safer longer term hands, where it can either be held, or extinguished.

Wolfgang Münchau, writing in this week’s Financial Times, was pretty unequivocal in his commentary, not altogether subtly entitled ‘Central bankers cannot stop this contagion’:

“For as long as this financial crisis persists, interest rates will be determined by toxic market conditions, not central bankers.. We may even be in a situation where low interest rates give us the worst of all worlds: no stimulus in the short run, and a rise in inflationary expectations in the long run.. What spooks investors is the loud and clear signal from central banks that they are not prepared to stabilise inflation in adverse circumstances.

“This has not been a liquidity crisis, but a hugely contagious solvency crisis, affecting sector after sector, starting off with subprime mortgages, spilling over to the rest of the mortgage market, into municipal debt, corporate debt and many obscure sectors of the financial market.. It will spill over into the rest of the financial market and to the real economy. Perhaps there exist some regulatory devices one could deploy to mitigate the forced-selling problem. [If there are, we can count on the Bernanke Fed to use them.] I suspect we will ultimately end up with some combination of regulatory relief, fiscal bail-outs, nationalisations and many, many bankruptcies of financial institutions not too big to fail.” (Emphasis mine.)

As far as credit markets are concerned, we are evidently entering something of a ‘new paradigm’ world, at least as far as securitisation, credit quality assessment and asset-backed lending are concerned. Unfortunately, while the Fed is at least behaving pro-actively to attempt to forestall further dislocation in the US financial sector, central banks like the ECB are still doggedly fighting the last war against inflation. Inflation is unlikely to be a significant issue once the economy falls into the grip of an economic recession. Rises in commodity prices, and specifically the price of oil, will ultimately be self-correcting (though non-replaceable commodities affected by robust global and Asian demand, and which have seen decades of underinvestment in capacity, may have some way further to run). But in any case there is little that central banks can do to address commodities prices, nor should they try: there is enough manipulation of the money supply going on; the price discovery process in credit has already been suspended by the intervention of the monetary authorities (if only all markets had such powerful ‘Get out of jail free’ cards). We do not need intervention in commodities prices when free markets can and ultimately will lead to some form of equilibrium.

If Wolfgang Münchau’s scenario comes to pass (and we have some sympathy with it), the implications for investors are severe. Coming at a time when public finances in the Anglo-Saxon economies are already stretched, the requirement to support major banking institutions with taxpayers’ money would positively murder the government bond markets. It is for this reason that we still see inflation-protected government debt as the ‘least worst’ debt market investment, inasmuch as investors are hedged against the inflationary scenario, but still given high quality credit exposure and a minimum income – even if the ultimate outcome is actually one of disinflation (consistent with a major economic slowdown). As for equity markets, we continue to see merit in being highly selective. This is not an environment conducive to broad market-based exposure, rather one supportive for very specific businesses outside the financial, homebuilding and consumer arenas . Classic defensive stocks are becoming increasingly hard to come by: the bloom has come off both pharmaceuticals and to a lesser extent telecoms; tobacco stocks are expensive; food company stocks are afflicted by the vicious rise in soft commodities prices; packaging stocks by equally vicious rises in the price of raw materials. One feels that the broader equity markets are now pricing in some degree of (relatively benign) slowdown – what they are not pricing in is another leg down triggered by genuinely new significant bad news on the financial front, such as the failure (or more likely emergency bail-out package triggered by the failure) of a mid- or large-sized financial institution.

A ‘new paradigm’ market environment requires a different sort of investment thinking from the traditional. Return of capital trounces return on capital when the financial markets have become essentially unhinged. Preservation of capital – in real terms – becomes the primary objective. In this world, cash alone does not do the job. It needs to be bolstered by high quality credit, ideally of unimpeachable quality – but try finding that in an environment where ‘AAA’ no longer means what it used to. There are other forms of money, and precious metals represent them. The commodities bull is not dead yet. As Dr. Marc Faber suggests in the context of gold,

“Central banks around the world have no other option but to print money and this will lead to a further depreciation in the value of paper money against precious metals.. But when we consider the upside potential of gold compared to its downside risk, the biggest mistake an investor could make is not to own any gold at all.”

Of course, gold – and other metals, platinum and palladium – could easily see substantial pullbacks from current levels. But since they represent in large part the portfolio insurance of financial assets, a retrenchment in the price of gold would be consistent with a recovery in the price of those assets, and vice versa.

Cash needs to be bolstered, too, by ‘growth’ assets – which we would define as those exposed to the secular growth story of global infrastructure spending and energy and resource provision in both the developed and developing world. There will be pockets of sustainable value elsewhere in the listed equity markets – but investors will have to have an iron constitution (and certainly a patient one) to withstand the shorter term price turbulence inherent in a world of urgent deleveraging and forced selling. There will evidently be opportunities in hedge funds – but given a ‘shoot first, ask questions later’ retrenchment by prime brokers, not all will make it through the pass intact. Diversification, and a concentration on quality in assets of all forms would seem to be the order of the day.

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