Commentary – Quarterly bulletin

Confidence, confidence, confidence

Confidence is a fragile commodity that, once lost, takes time to rebuild.

8 October 2008

What started as a small problem associated with sub-prime residential mortgages in the US has escalated into the biggest global financial crisis since the 1930s as confidence amongst those operating in the wholesale money markets has all but vanished. There are a whole series of contributory factors to this sorry state which will no doubt keep book publishers in business for some time but to which this short commentary cannot do justice. We are in a downward spiral which can only now be halted by meaningful government intervention as they are the only participants that can, courtesy of taxpayers, provide the necessary floor to asset prices and stabilise the system.

Without reaching stability there is a risk of economic collapse.

Regardless of what happens next in the unfolding financial crisis, the global economy is likely to hit a recession. Already, some economies are contracting and it is just a matter of time before we read headlines about recession in the UK, the US and other major countries in the developed world. We have to hope that swift action by the authorities in the form of capital injections into the banking system and lower interest rates is enough to prevent an extended recession.

Banking system failures are more common than you might expect.
The International Monetary Fund has documented more than one a year on average since 1970. Most of those have occurred in emerging economies so what we are now facing is a more serious threat to the global economy than most of the others. Nevertheless, they all came to an end and conditions eventually returned to normal. It’s just a question of how we get there and what the cost to the taxpayer will be once the dust settles. The following graph shows this cost for a selection of failures. What is clear from an analysis of these events is that it can take many years for the final cost to be known as assets which are transferred to the public sector either mature or are sold back to the private sector. Interestingly, the body that was set up in the US during the 1930s to refinance housing loans was eventually wound up in 1951 with a net gain to taxpayers.

Cost of government support to banking system – figure 1

Perception on inflation has changed abruptly in the face of slowing growth.

Investors have stopped worrying about risk of inflation in a dramatic turnaround from only three months ago. With commodity prices falling, no sign of wage growth acceleration and the prospect of much weaker economic growth than was expected, the fear that inflation may get out of control again has completely dissipated. Even the European Central Bank which until very recently remained in hawkish mode regarding inflation is softening its tone and is now likely to join the band of interest rate cutters over the next few months.

Equity markets are now pricing in a lot of bad news.

Valuation measures are now relatively attractive but this is insufficient to turn markets around. It is still possible that the coming profit decline will cause further market weakness and if the credit markets continue to be dysfunctional, companies may conserve cash by cutting dividends. Falling interest rates, however, should provide a strong counterbalance to these potentially negative forces. With the Bank of England official rate at 4.5% there is plenty of scope to cut rates further should circumstances require it. It is worth reminding ourselves that equity markets normally bottom out well before the business climate improves. Currently, investor fear is at a high level and that too is a sign that we may be closer to the turning point, but yet again it comes down to confidence. Something has to shift the balance of willing buyers and sellers in favour of the former and in the past, interest rate cuts have often provided the spark. This time, because of the breakdown in the normal transmission mechanism, interest rate cuts may lack their normal potency. Additionally, investors will be seeking greater clarity about how the financial crisis will be resolved and the degree of economic pain that will be endured. We should certainly expect equity market volatility to persist for some to come as these positive and negative forces battle it out, but long-term investors buying at current prices should eventually be rewarded.

The traumas in the credit markets have been responsible for driving gilt yields lower again as investors flee to risk-free assets.

Furthermore, lower inflation expectations have helped. So far, demand for gilts has been outstripping supply but that may be about to change. The graph below shows the UK government annual surplus/deficit and the outstanding debt since the mid 1990s. The ‘ship of state’ takes a while to turn and for the past six years or so the trend in government finances has generally been negative. The prospect of an additional debt burden caused by intervention in the banking sector as well as the normal cyclical deterioration in the operating balance during an economic slowdown suggests that gilt issuance is likely to rise significantly in the next few years.

Investors have also been moving out of commodity markets as they reassess the global economic outlook.

Lower demand has temporarily undermined the long-term bull case for commodities. Over the past few months we have seen commodity prices tumbling as investors rush for the exit. Gold has been a notable exception as people once again turn to this asset for its security value. At times of financial stress, the gold price is almost an inverse measure of confidence in the banking system. Accordingly, if we see gold weakening significantly it may be a sign that the financial crisis is being resolved. It will probably take clear signs that the global economy, but particularly the emerging economies, are shaking off the effects of the financial crisis before we see the next sustainable rise in overall commodity prices.

— Ken Forman

Ken is an investment business consultant who spent 30 years as an analyst and portfolio manager at Standard Life Investments.