“The national
budget must be balanced. The public debt must be reduced; the arrogance of the
authorities must be moderated and controlled. Payments to foreign governments
must be reduced, if the nation doesn’t want to go bankrupt. People must again
learn to work, instead of living on public assistance.”
- Cicero, 55 BC. (Note: Edward Gibbon dated the actual fall of Rome to AD
476, over five centuries later.)
If ludicrously
overblown press headlines were a definitive contrarian guide, the financial
crisis has reached its nadir. Fortune
went last week with ‘The end of Wall Street as we know it’. If only. The London Evening Standard billboard,
long a source of gaudy amusement to weary commuters, went with ‘BANK CRASH:
LONDON PANICS’. (The Standard, of course, has some form here. Previous measured
coverage of topical events from the paper that never discovered lower case has
included ‘TOXIC CLOUD HITS LONDON TONIGHT’; ‘THAMES FLOODS: PREPARE TO FLEE’;
‘TOOTHPASTE CANCER ALERT’; ‘EXPLODING LAPTOP COMPUTER ALERT’; ‘KILLER FOG
TRAVEL CHAOS’; ‘AAAAAARRRRRRRRGGGGGGGGHHHHHHHHHHHHH!’ (this last entry looks
suspiciously like a fake – judge for yourself); ‘IPOD HEALTH
ALERT’; ‘EUROPE: IT’S WAR WITH FRANCE’; ‘INSIDE HORROR PUPPY FARM – PICTURES’;
‘SUMMER KILLER WASPS ALERT’..) Other coverage was more nuanced. The Financial Times on Tuesday led with
a somewhat baffling photo from the Chicago Mercantile Exchange of someone arms
akimbo who may just have been ordering a cheeseburger. The Daily Express, admirably meeting its journalistic
responsibilities in addressing the biggest markets crisis since World War 2,
led with a headline about Princess Diana.
With the fifth
largest US investment bank having been repackaged and sold at distressed
valuations to what is now the largest,
and with several UK banks now optically at least yielding over 10%, it would be
redundant to say we are living in extraordinary times. But we are, and as
Citigroup’s Patrick Perret-Green points out, desperate times require desperate
measures:
“It is time for
Federal involvement no matter how distasteful the issue of moral hazard is.
There are times when only the public sector can halt the rot. I believe that
this is one of them. GSEs (Government Sponsored Enterprises, namely Fannie Mae
and Freddie Mac) and munis need to be guaranteed and the White House needs to
exercise its executive muscle. If it means that you have to replace your
Treasury Secretary to enact the equivalent of a “surge” then so be it..
“Equally
significant is that it is time for the other firefighters (central banks) to
become much more involved. The fire may be centred in America but the sparks
are floating on the wind and too little has been done to prevent it
spreading..”
From a
behavioural perspective, one of the slightly
more positive straws - as opposed to sparks - in the wind is, perversely, the very
failure of Bear Stearns: traditionally, the collapse of a major institution
would have been treated as symptomatic of the low being in, or at least close
by.
It is a sign of the times that no sooner had Bear entered the welcoming arms of
JP Morgan than the market sniper was directing his crosshairs at the likes of Lehman
Brothers and MF Global. The difference this time round would seem to be that
the crisis, like the financial system and the international economy, is
properly global. So there are likely to be more Northern Rocks and Bear Stearns
to fail before the worst can be said to have passed. Particularly in Europe,
where the monetary authorities have been surprisingly grudging to offer the
financial sector anything (other than simple liquidity) by way of meaningful
emergency support in comparison with the Fed. One other, significant,
observation: if we are entering a realm of much enhanced government (i.e.
taxpayer-) funded support for the financial sector, that is occurring at a time
when government balance sheets are already a disaster. Government bond yields
run the risk of exploding upwards in an environment of further emergency
bail-outs for badly run banks or near-banks.
But then these
are extraordinary times. RJH Adams,
conversely, takes a less than charitable view of the Fed’s energetic and
creative intervention:
“And now the Fed
has decided, post Bear Stearns collapse, that even more largesse is required
for the troubles at hand – this time including non-banks and allied to terms of
greater secrecy.
“This latter
feature is both a sop to financials wishing to preserve their reputations
which, for some curious reason, they collectively appear to believe are
currently held in high esteem; and to stave off depositor / client scrutiny and
exit.
“The secrecy is,
viewed in these terms, a deception upon shareholders and a symptom of a weak
banking supervision regime. Banks in difficulty are being allowed to hide and
roll over their solvency issues (where they can) in the hope that their
catastrophic losses on assets held prove transitory with the underlying
security at some future point marketable.
“So far the
opposite is happening and yet this behaviour is likely to continue until the
Fed eventually comes up with a package soft enough to persuade the banks (and
other financials who, like Bear, will find an indirect way to access Fed
support) to take it up anonymously.
“Maybe the Fed
just did that; but the opacity of the deal destroys confidence more than the
fig leaf excuse of protecting banks’ operations merits. Here is the point: it
is currently impossible for investors to determine which banks / other
financials are solvent. Allowing all and sundry to tap Fed offers can only turn
out to be a drag on the broader economy and delay final settlement.. Banks need
recapitalization. That requires transparency – and that someone takes losses.
Just ask your average shareholders like Mr. (Joe) Lewis (whose Tavistock Group
owns 9.4% of Bear Stearns) and Citic (a Chinese brokerage that agreed in
October to invest $1 billion into Bear Stearns). Buying time and pretending
otherwise is wishful thinking.”
Not every debate
last week was over the appropriateness of Federal Reserve support for
broker-dealers and other members of the so-called shadow banking system. In a
timely piece for The Financial Times, investment consultant David Roche wrote
of the commodities ‘lifeboat’ being swamped in a rush to safety:
“In the current
turmoil, there has been a rush into commodities.. the speculative element has
grown sharply.. (but) global growth is declining fast. Recession will ensue and
no region or asset class will be immune from its ravages..”
Roche suggests
that as the Chinese authorities tackle domestic inflation (unlike their western
counterparts), China’s growth rate could easily fall by, say, 3% to 8% - which
“would remove the ex-ante global supply / demand deficit from energy markets
and push most industrial metals, including steel and copper, into significant
surplus.. we can expect the price for refined oil to fall 30% and industrial
metals by 20% to 30%. The big fall is coming.”
Since
commodities, and more particularly softs, have recently been the only game in
town, Roche’s suggested correction leaves investors with something of a
quandary. Government bond yields are pricing in hell on earth. Equities and
corporate bonds are trapped in a bear market, along with the US dollar and
confidence in the international banking system. If commodities join them, where
can despairing investors go – either in search of profits, or simply to preserve
capital ?
One response
would be that a commodities correction might be short-lived: limited, perhaps,
to the extent that a Chinese slow-down takes some of the heat out of the
market. If it turns out to be an altogether longer-lived correction, even that would
be nothing that BMO’s impressive global strategist Donald Coxe didn’t foresee
as far back as October 2003 (‘Basic Points: A major investment sonata in a
miner key’):
“Within months,
this Movement will probably end. Whether it will come from disappointing
economic news.. or simply because stock prices have gotten ahead of themselves,
one cannot know..
“The Second
Movement will mean further development of the [commodities] theme, but will be
more stately, and will frequently be in a minor key. At each of those
intervals, the miners will rediscover their primal fear: they must not be up
dancing when the music stops.”
Donald Coxe goes
on to explain that the Second, or middle, movement of symphonies was
historically a shorter movement that gave the orchestra a chance to cool down;
“Since stock prices for the leading mining companies [and the prices of most
commodities] will be up so hugely as this movement begins, there will be itchy
portfolio manager fingers to take profits as the rest of the stock market
encounters downdrafts..”
Again, given
that Coxe was writing these words in October 2003, he deserves bonus points for
prescience. As he then pointed out, in relation to the metals markets (but
surely his words have a broader resonance for the entire commodities complex):
“..the
demography of the market.. includes those too young to have seen a true bull
market for mining stocks, and those who remember all too vividly the ghastly
bear market of the 1990s, and the ups and downs of the 25 years before then.
Within the mining industry, the aged players are battle-hardened and cautious.
Youth doesn’t understand, and age doesn’t believe.”
David Roche may
well be right in the short term in relation to the overvaluation of
commodities, but in the longer run his argument is up against some significant
headwinds, including: a secular shortage of supply (40 year low inventories in
the case of some agricultural softs); a multi-decade bear market before the
most recent gains; the new ease of access into the sector, in the form of
low-cost exchange-traded funds; the chronic underweightedness of institutional
investors (see, for example, our commentary ‘All in the mind’ of 7th
March, which cited a Bloomberg report claiming that the Calpers pension fund,
the largest in the US, having made its first investment into commodities in
2007, was considering increasing its investment some 16-fold); the demand
shock represented by a newly emergent and newly wealthier Chindia; a US
monetary policy regime that seems determined to sacrifice the dollar on the
altar of banking system survival. Commodities markets are always going to be
volatile, but rarely have there been so many fundamental reasons to be positive
about their longer term prospects in an otherwise acutely unstable world.
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