The Monte Carlo Report

Views on the shape of the recovery

2010-04-21T22:45:00.000-07:00

Last week I met the Iveagh fund manager who touched on the shape of the recovery and it got me thinking about it in more detail. He says we are probably experiencing a v-shaped recovery and that he doesn’t see a double dip coming for economies or markets (although he has only become confident about this during the past 3 months). It made me think about what people would actually be seeing and feeling even if a double dip scenario was ‘in progress.’

The double dip scenario looks like a large W.

We have been down the first part of the w and are now climbing up the second part, so it could still be a V-shaped recovery. However, in order for markets to start this climb up the central part of the W there has to be something driving it. Therefore, one would need to see positive economic indicators and positive stock market sentiment to drive the rise, which is exactly where we are today.

If we were seeing predominantly negative indicators for the economy and stock market then it is unlikely that we would be climbing out of the trough and we would be experiencing something that more closely resembles an ‘L’.

In short, the optimism that we are seeing now, that is built on the belief that the worst is behind us and we are on a sustainable up-trend, is an essential part of a W-shaped recovery which means it is too early to discount the possibility of one occurring.

For the next stage of the W to pan out there would need to be something on the horizon that could derail an economic recovery and knock stock market sentiment. With interest rates at close to zero and government debt levels at record levels a combination of rising rates, higher taxation and government spending cuts is a foregone conclusion and could be the catalyst.

For the V-shape recovery to pan out we need to see growing consumer spending in the West, falling unemployment and stronger corporate investment. This will need to occur against the headwinds mentioned above.

I can see why an optimistic investor could argue that we are enjoying a V-shaped recovery but I also think that it is still too early to say that we are out of the woods as the current economic environment is as much a prerequisite for a W-shaped recovery as it is for a V-shaped recovery.

Is the commercial property sector facing a long-term decline in demand for shops and offices?

2010-03-22T01:30:00.001-07:00

The government has announced it is going to put as many services as possible online in the next few years. Ministers and their advisers are currently drawing up plans to move the delivery of services relating to passports, job centres, benefit offices and town halls onto the internet. Tens of thousands of public sector jobs could be ‘streamlined’ as a result. This highlights a growing trend in society and suggests that we might already have enough shops and offices for our future needs. Modern life is evolving because technology is forcing rapid changes to the way we work and the way we live and this announcement to cut jobs in public services by automating processes and putting services online is only the tip of the iceberg. The internet is to 21st century industrialisation what the production line was to 20th century manufacturing.

Ever since dotcom euphoria started to take hold and online business began to look like it would change the world people have been claiming that the end of bricks and mortar business is in sight. We got slightly ahead of ourselves by a decade or two but things are changing rapidly now, driven by the need to cut costs, better technology, widespread wireless communication and a need to adapt to a new generation of adults that are completely at home in the virtual world of instant messaging, social networking, text messages and online commerce. These changes, at the very least, raise the question: how many more shops and offices do we really need?

According to a recent report commissioned by the British Council of Shopping Centres, one in five shopping centres in the UK are at risk of defaulting on loans, which suggests that demand for new retail space is weak whilst supply is still growing. There has been a huge amount of new retail space built during the consumer boom and this has continued to some extent during the past two years as lead time from planning to completion is quite long and shopping centres such as Newcastle’s new £170m mall that was opened in February this year will have been conceived before the UK went into recession. By mid-2008, just as the downturn hit home, the rate of retail space development was at its highest for 40 years. Some developments have been postponed since then and some projects have been cancelled altogether due to a lack of financing but there is also a drop in demand from retailers who are experiencing a downturn in consumer spending. It is possible that the nationwide volume of retail space when combined with the potentially long-term effects of the financial crisis could mean that we have sufficient supply for decades to come.

The huge expansion in personal loans, leasing, equity release, credit cards and mortgages in the years leading up to the start of the financial crisis has created what could turn out to be unnaturally high levels of consumer spending, especially in the UK. We are now seeing an increase in the savings rate as households attempt to unwind their high debt levels and this will have a negative impact on retail spending overall whilst it continues. This level of spending might fluctuate in the short term but for the next few years it could actually decline in real terms as consumers come to grips with weak pay increases, persistently high unemployment, reduced government spending, higher interest rates, higher inflation and higher taxes. A decline in spending power hits retailers directly and they may be forced to continue cutting costs and streamlining their operations. Past experience suggests that they will close underperforming stores and focus on improving sales from better-performing locations whilst trying to boost online sales as much as possible. The net effect could well be less need for new shops.

Technology is also having a significant impact on consumer shopping habits. According to Retail Decisions, a card payment business, online sales in the UK increased by 21% between 2008 and 2009 and up to 33 million people made a purchase online. There is a growing tendency for shoppers to spend their time in shops at weekends and then to make their purchases online during the week, with Monday traditionally being the busiest day for online sales. The role of shops is changing and they are often used by consumers simply as a means to physically view items before searching online for them at a better price. The rise of smart phones, such as the iPhone, and netbooks is also making this easier as shoppers are now able to obtain an online price comparison of an item whilst standing in a store looking at it. Portable widespread access to the internet is making it easier and quicker to shop around without moving and online retailers often have a price advantage because they don’t pay high rents for prime retail sites. The extrapolation of this trend, as 24hr online access and the prevalence of browser-enabled portable devices make accessing the internet much easier, suggests that online competition will continue to intensify for bricks and mortar-only businesses.

Demand for office space is another sector under threat on a long-term basis. Outside of London rents are expected to fall during 2010 due to oversupply and the public sector cutting back on workspace requirements. The need to be physically close to other people is diminishing rapidly as communication via the phone and the internet is improving and becoming more widespread. The ability to speak to people and to see them via a webcam is becoming more mobile, less expensive and of much higher quality. The idea of a face-to-face meeting between 2 people in separate cities is now entirely possible and the use of video-conferencing is expanding as it saves time and money whilst still enabling participants to read expressions and body language. Only the physical handshake is missing from the meeting.

The concept of working at a distance has been around for some time but there are certain catalysts that might cause a significant step-up in the evolution of the process. The financial crisis could be one such catalyst, especially if we see the economy drop back into recession, another could be a change in government policy such as tax breaks for those who are prepared to change their habits, but change will probably come more gradually. Advances in technology are making remote working easier and cheaper as mentioned and as companies have sought to cut costs during the recession they have reduced spending on business travel (high and rising fuel prices haven’t helped) and have looked at ways to reduce fixed overhead costs such as office space. The financial crisis has made ‘streamlining’ a priority for businesses that only needed to focus on managing expansion during the boom years and a drawn out period of weak growth could see this continuing for longer than usual.

One particular theme that is rapidly gaining prominence is the misery of commuting and congestion for workers travelling to and from their workplace on a daily basis. The sheer numbers of people moving around the country, especially at rush hours, makes the idea of working from home increasingly more appealing. The roads are already clogged up so imagine what they will be like in 10 or 20 years time if society continues on its current course. The threat of transport strikes as unions fight with employers and the government about pay rises only highlights how pointless so much commuting really is. Home working saves wasted time (some people spend 3 hours a day or more going to and from work), whereas commuting costs money, can be stressful and adds greatly to pollution. Whilst there will always be a need for certain jobs to be located in one single office, I believe it is unlikely that we will need a growing number of centralised workplaces over the longer-term when the alternative is becoming more feasible and more attractive.

I’m not suggesting that the construction industry will disappear, there will always be a need for new buildings, even as technology brings changes to requirements. For example, the adoption of the desktop computer helped automate offices but businesses also required new building designs to accommodate all the cabling under floors and through ceilings. In turn it is likely that changes in technology and their effects on our lives will create new ‘machines’ for living and working (as Le Corbusier described them). Online businesses require warehouses to store goods and an expansion in distance working could see more residential development being adapted to suit the requirement for work space in the home, but the net overall effect is that the migration of services into the online world could change the physical landscape of the country and this would have massive repercussions for the commercial property sector as it stands today.

The Nightmare Scenario for Britain’s Property Market.

2010-03-03T07:43:00.000-08:00

The nations favourite conversational subject for many years has been that of house prices and the state of the property market. In spite of a significant downturn in the market since the credit crunch began, we have recently seen evidence of a revival in prices and renewed enthusiasm for the sector as we hear reports of auction houses crowded with property developers looking for a bargain. Buy-to-let investors seemed to have scraped though the crisis and property-related programmes show no signs of disappearing from our tv screens. It was a downturn but not the major crash so many people expected. But what if this was just a taste of what is still to come?

It looks like the huge drop in base rates to 0.5% has staved off a lot of potential pain for the nation’s homeowners but things could be very different if interest rates were forced to rise substantially. By current standards the 1970s and 1980s were characterised by persistently high Bank of England base rates, until they started to come down in the early 90s. These lower rates then laid the foundations for the rise in house prices that started in the mid-1990s and continued their seemingly-unstoppable ascension until the peak in 2007. However, the Bank of England has no more room for manoeuvre, base rates only have one possible course from here: up.

Under the current arrangement between the government and the Bank of England it is the Bank that is responsible for inflation targeting and it is inflation that is the most likely reason for interest rates to go higher. Whilst the Governor of the Bank of England was recently forced to write a letter of explanation to the Chancellor, as inflation reached 3.5% year-on-year in January, the Bank still expects inflation to fall back below this level later in 2010. However, there are growing signs that inflation may yet become a force to be reckoned with.

The Pound has dropped nearly 5% against the Euro in just over two weeks. Europe is the UK’s largest trading partner and the falling Pound means that imports from the Eurozone have suddenly become significantly more expensive. Sterling has also recently weakened against most other currencies, many of which have their own problems to face, which indicates the low esteem in which it is held today. The UK’s dire financial situation and the threat of a hung parliament have led investors to reassess our ability to pay down debt and this is weighing on the Pound, to the extent where some commentators are talking of the Pound/Euro exchange rate falling below parity and with the possibility that the Pound will keep on falling beyond that level.

Whilst UK exports would undoubtedly benefit from a weak Pound the reality is that life in the UK today relies heavily on imports and a severe drop in the Pound pushes up prices for everyone. If the government decides that Sterling has weakened too much, to the point where it seriously undermines the fiscal credibility of the currency, then the government may be forced to defend it, as it did in 1992 when Sterling was forced out of the ERM. Even though the currency is now free-floating and events would not exactly mirror those of Black Wednesday, the question remains: what action would the UK government take if a beaten down Pound meant that import prices were forced up sharply? This could soon feed through into inflation figures and everyone knows that strong inflation is very hard to tame once it becomes imbedded.

If UK interest rates were forced up suddenly to relatively high levels, in order to stifle inflation and to make the Pound more attractive, the effect on the UK property market could be devastating. House prices are still about 40% above their peak in the 1980s housing boom, even adjusted for inflation, and much of that rise has been fuelled by an expansion in mortgage lending. Household debt levels are still high, there are still plenty of examples of high levels of corporate debt (especially in the commercial property sector) and now government debt levels are also very high. In the event that the interest rate on a large proportion of this borrowing was raised significantly then we can expect to see extremely severe stress in all sectors exposed to high debt levels and in particular the property market.

If the Pound continues to weaken substantially from here then it won’t be long before something needs to be done to support it. If rate rises aren’t forthcoming then Sterling could remain weak for some time and that means import prices will stay high. Either way, it’s not good news for the UK economy. Relatively few distressed assets have come onto the market during this recession because the banks have largely been able to service debt at historically low interest rates and they have therefore been able to avoid putting them up for sale but this could all change if interest rates are forced up. Rising yields on Greek sovereign debt have already highlighted how worries about debt servicing can push up interest rates on borrowing and the threat of a downgrade to the UK’s triple-A credit rating have been a reminder of concerns about the UK’s own fiscal situation.

Some hard choices will have to be made about how to deal with the UK’s debt burden at some point but it wouldn’t surprise anyone if it turned out that the political will to deal with the problem was lacking. Unless the economic situation improves without the requirement for ongoing government fiscal stimulus then investors will choose to avoid Sterling or they will demand a premium for holding it, both of which suggest that interest rates will need to rise. If this rise is badly managed by the Bank of England then the bond market will probably force a change. If interest rates shoot up then investors that managed to preserve their capital during the downturn, and who are not heavily leveraged today, could find that the investment opportunities of a lifetime might finally start to appear.

Why 2009 is not 2003

2009-11-06T03:16:00.000-08:00

This article was written at the start of September 2009.

There are many parallels one can draw with the stock market rally we have seen since mid-March (earlier in emerging markets) and that of the start of the last major stock market rally that started in 2003 and ended in 2007. Many investors appear to believe that, just like then, this is the start of a much longer bull market that could go on to reach the heights of the previous two bull markets. However, there are a number of reasons why this rally is very different from that of 2003 and many of the others throughout history with which it is being compared.

A good reason for comparing this rally with that in 2003 is that it began in the trough between the peak market levels of 2000 and 2007, both of which shared certain similarities in some important markets. For example, if you look at 15 year charts for the S&P500, the Nikkei 225, the FTSE All Share, the FTSE 100 and the CAC 40 you will see that they all shared double top formations with markets peaking at similar levels in 2000 and 2007. None of them have exactly the same pattern but there are clear similarities in the index levels which all peaked only a few percentage points apart.

The second interesting similarity is that each of these markets also bottomed out at around the same level in 2003 and 2009. Therefore, having peaked in 2007 at the same level as in 2000 and then rebounded from low points in 2003 and 2009 there now appears to be an assumption that we will see a second repeat of the climb back up to the highs of 2000 and 2007.

The bull market in stocks that peaked in 2000 was a big one. By the time the dotcom bubble had burst and investors realised that they may have overestimated the way the internet would change the world, individual stock valuations had reached new heights. The S&P500 had a PE of 46 by the end of 2001, a year in which the September 11th attacks in the US also contributed to negative investor sentiment and were blamed for a large number of companies issuing profit warnings. The market fell until the first half of 2003 before bottoming out.

The story behind the 2000-2003 market decline was very much about valuations. Stock prices had become far too inflated relative to earnings but that wasn’t the case when markets peaked in 2007. At the end of December 2007 the PE for the S&P 500 was 19.84, which is not cheap but is lower than in 2000 when it stood at 26 and especially compared to the 2001 valuation of 46. Instead of a simple overvaluation of stocks, the boom that led up to 2007’s peak was fuelled by increased earnings that had been inflated by a massive expansion in credit at the customer and corporate level.

A stock valuation which is inflated by exuberant investors is easily corrected by a stock market fall but the when the problem is of a more fundamental nature then a simple stock market correction does not solve the underlying problem. I would argue that we are seeing a long-term correction to corporate profits as a result of a global contraction in credit and the spending power that it afforded us, and this reflects a long-term change in the way the global economy works.

The 2000 bull market was fuelled by a bubble in stock valuations and when interest rates were lowered it was followed by a bubble in the accessibility of credit that fed into many elements of the wider economy, leading to a global property boom amongst other things. High market peaks leave investors with high expectations for future market peaks. If we are to see stock markets ‘recover’ to former levels within the next decade then it would appear that we need either a major positive fundamental change to the way the economy works or we need another bubble.

In my view it appears that there are more negative fundamental differences at play today than positive and there are several important differences between the economic environment of today and that of 2003 which suggest that this market rally will not be sustainable.

a) From 2002, US GDP was never technically in recession and in the period from 2000 to 2007 it never contracted for more than one quarter at a time, having shown negative growth on just two occasions. Conversely, from Q2 2008, US GDP contracted for 4 quarters in a row which suggests that the economy is in considerably worse shape today than it was during the last stock market crash. Many countries have experienced negative GDP growth whereas they didn’t during the last downturn.

b) The 2003 rebound was fuelled by pent up consumer demand that had been dampened after the 2000 stock market crash and also by the negative effect of 9/11. The US consumer had been able to continue his spending in spite of the supposed economic downturn and household consumption rose in every year from 2000 to 2007 . In 2003 consumers had the ability to spend whereas today they are far more indebted and they have more restricted access to credit, both of which will severely curtail their spending.

c) Today they are also more likely to be out of work. From 2000 to 2003 the US unemployment rate rose from 4% to 6%, which was a significant increase but was nothing compared to the change since mid-2007, when the US unemployment rate rose from 4.7% to 9.4% by July 2009 .

d) This year we have seen total US household debt shrinking whereas in 2002 and 2003 it was still growing as consumers were able to leverage the value of their properties and use money released from equity for other spending.

e) US house prices rose every year through 2000 to 2006 . This was a major boost to spending power and consumer confidence which is completely missing today. US house prices have fallen substantially since their peak thereby removing the ability and the desire to release equity for spending.

The flipside of the negative factors above is that government intervention directly into the economy during the last downturn was nowhere near as significant as today. Whilst quantative easing and the purchase of government bonds are an attempt to restore ‘normality’ to lending costs, the wider economy should today also feel the positive effects of the subsidies for new cars, tax cuts such as the UK cut in VAT and the US income tax rebates which put money directly into circulation. However, these schemes have had limited success because they encourage a short term spending spree, they bring forward spending that would have occurred later or they have diverted spending away from other areas of the economy. Some of this money has also been used to pay down debt or to rebuild savings. We also know that such methods of stimulation have a finite life, they can’t be sustained indefinitely, and they also have to be paid for at some point in the future.

Another example of ‘distortion’ in the market is that many companies have been kept alive by a combination of support from the government and financiers. In Italy only one publicly traded company has filed for bankruptcy this year even though many more are unable to pay their loans. In a normally operating free market many companies would have gone out of business and this would likely have had a more damaging effect on investor confidence and stock markets in general. It is another example of the difficult and unusual investing environment we have to contend with today.

The evidence shows us that much of the global economy is in a worse state today than it was in 2003 and that many of the problems that led to the credit crunch have not yet been solved. GDP growth in developed economies is forecast to be extremely weak for the foreseeable future, company directors who are selling their own stock outweigh those buying by a record amount, there are a record number of homeowners in negative equity (8m in the US) and 9% of US mortgage holders have defaulted, having missed at least one monthly mortgage payment. We are still at risk from banking collapses where banks have high exposure to commercial property lending, credit card debt or Eastern European investments. Unemployment is still rising in many countries.

It would appear that the global economy, and the environment for corporate profits, is considerably worse today than it was in 2003, yet the major stock markets have rallied significantly since their credit crunch lows. The factors I’ve highlighted above would tend to suggest that a recovery in corporate profits is far less certain than stock markets would have us believe and the higher markets go without a solution for the fundamental problems then the greater the likelihood of a major correction.

Several major stock markets have fallen no further than they did in the last bear market and this is supposed to be telling us that the worst recession since the 1930s actually has a relatively limited negative impact on corporate profits. With the exception of the financial sector, the valuations of most stocks have not fallen to the kind of low levels seen in previous bear markets. This does not make sense to me and it makes me doubt the validity of the forecast upturn. A v-shaped recovery was always seen as the least likely course of events but that is what markets appear to be pricing in. The points I’ve highlighted here suggest that a return to an economy similar to that experienced in 2003 looks like a rather distant possibility and investors could well be disappointed when economic reality fails to catch up with the stock market rally. The question is whether this results in a new downward leg of the bear market to new lows, or whether government intervention ensures that we only suffer a relatively minor correction and the markets remain on life support.

The Japanese were criticised for supporting ‘zombie’ banks during the lost decade of the 1990s, having failed to deal with the problem of non-performing loans in the banking sector, and it was this approach that was blamed for prolonging the severity of the downturn after their own stock and property market bubbles popped. I would argue that the leaders of the US and Europe are equally guilty of avoiding the need to take painful decisions and they are failing to address the underlying problems of the economy. Debt is being shifted from the private sector onto the shoulders of the taxpayer, companies that should fail are being saved from bankruptcy and over-indebted consumers are being incentivised to spend their way out of an economic crisis that was brought about by over-spending. These are short term solutions to long term problems and I fail to see what will provide the power to drive a sustainable stock market recovery from here. The factors that enabled the 2003-2007 bull market are not in place and there are no obvious alternatives in sight.

Some of my views on the Fed move to buy treasuries.

2009-03-20T02:07:00.001-07:00

The Fed announced this week that it will spend $300 billion buying US treasuries, presumably to bring down interest rates and to increase market liquidity (weren’t treasuries already liquid?). In the same week we have seen a drop in the Dollar and a significant rise in the oil price, the gold price and other commodity prices. OPEC probably can’t believe their luck, having only just announced that they would not be cutting production quotas further in light of the severity of the economic downturn.

Whilst it is early days, the rise in commodity prices raises some significant questions about the targeting and validity of the Fed policy. As well as bringing down interest rates the buying of treasuries is also another way of putting money back into the financial system, with the aim of feeding through to the wider economy and keeping inflation alive (specifically to avoid deflation).

Real world inflation is generally driven by two factors (ignoring specific supply bottlenecks) that cause prices to rise: wage growth and credit expansion. The 10 year US treasury yield is currently 2.6% which would suggest that it is not high interest rates that are stopping credit expansion. Extra liquidity in the system could help but what is really needed would be widespread take up of new credit by companies and consumers (not just a rolling over of existing debt, which wouldn’t be expansion). I would argue that most companies and consumers are still in deleveraging mode and will be for some time. I think credit expansion on a meaningful scale is unlikely to happen yet, maybe not for a long time.

Will the new Fed spending encourage wage growth? Not unless companies start experiencing increased demand (which won’t happen without greater disposable income for consumers, which itself would be a result of higher wages or lower outgoings). Wage demands that are satisfied by employers, are driven by rising prices in an economy but only where they arise from increased demand for goods and services. In the current environment workers will want higher wages because the cost of basic materials such as food and energy are rising but will employers be inclined to give them without a commensurate rise in demand for the goods they produce? Long gone are the days when an employer such as Henry Ford believed that paying higher wages to his employees would enable more of them to buy his cars.

So what if the Fed’s policy actually turns out to be damaging to the economy? In the period of a few short days the net result of the Feds treasury-buying policy is that it has pushed up oil, metal and various other food and energy commodities. The costs of production just got higher. So far, investor demand for inflation-hedging commodities has been sufficient to move their prices in anticipation of the higher inflation rates that could follow. However, if the net result of the Fed’s policy is to push up commodity prices initially, but it doesn’t feed into wages or credit expansion for the reasons mentioned above, then it is likely to put a brake on any hint of economic recovery that might have been occurring.

We are in unprecedented times and it is entirely feasible, in my humble opinion (!), that the Fed may be on the wrong path and it may actually prolong the pain of a recession. Higher prices are only desirable in the current situation if they lead to wage growth and reasonable credit expansion but if they only succeed in pushing up producer input prices before economic demand recovers then they are unlikely to get a warm welcome from either consumers or companies.

Is the luxury car market facing long-term decline?

2008-09-08T02:17:00.000-07:00

When you were little and you wanted to buy something your parents gave you the money, if you were lucky. Life was so much simpler when you didn’t have to worry about where the money came from, you just had to ask nicely for it (and do your homework). For many adults the first few years of the 21st century have seen this easy approach to shopping return and if you wanted to buy a car, the manufacturer or the dealer would offer you the money to buy it. If you look in detail at the car industry you see how cheap and easily available credit oils the wheels of this particular brand of commerce at so many levels and it has been especially successful at elevating the luxury end of the market into the mainstream.

The premium car market has boomed during the last decade, to the extent that in the UK the BMW 3 Series now outsells the Ford Mondeo, the Vauxhall Vectra and the Renault Clio. Throughout Europe BMW only sold 5000 less 3 Series than Ford sold Fiestas. The cars in the premium sector, even though they are considerably more expensive than their rivals, have enjoyed huge sales increases at the expense of the more mundane brands as people have been able to upgrade due to easily available finance. Some of the main beneficiaries of this step change in spending habits has been BMW, Mercedes (owned by Daimler) and Audi, all of whom have seen their luxury car ranges move into the mainstream. BMW and Mercedes in particular have benefited from the increase in demand for SUVs with their popular X5 and ML models, with Audi coming late to the game. According to the Society of Motor Manufacturers and Traders either Mercedes or BMW take the top place for sales in the Upper Medium, Luxury Saloon and Executive sectors of the UK car market. 4 out of the top 5 Sports cars on sales in the UK are German. In fact, German-owned marques dominate the top of all these sectors despite the fact that they tend to be more expensive than the equivalent models from other marques.

The expansion of the German car manufacturer’s sales in the last decade has come about as a direct consequence of rising aspirations and the ability to achieve them. Whilst ownership of a BMW or Mercedes used to signify a certain level of success, today these marques are accessible to a far more wide ranging section of society and they are a lot less exclusive than they used to be. In addition, new car ownership has increased in the UK so that we now have the youngest fleet of cars on the roads in Europe. This is probably best explained by the fact that the UK has the highest proportion of cars purchased with loans and it is this reason that explains why the premium car sector has been able to increase its market share.

Globally, one in three Daimler Group vehicles is bought on finance that is provided by the company itself. As well as being a major car manufacturer the Daimler Group is also the world’s largest manufacturer of trucks, and as economic activity around the world has increased, so has demand for their trucks. At BMW, nearly one in two vehicles is purchased using BMW-supplied finance and they also offer their own credit cards, home insurance and savings accounts in certain markets. To drive expansion of the distribution network they lend money to dealers to enable them to make property purchases and to buy stock and equipment. Last year nearly 20% of BMW Group profits came directly from their own financial services division. It’s clear that the ability to lend and borrow money is a crucial part of the business model for the major car companies.

However, the credit crunch has changed the dynamics of car retailing. Buyers are finding it more difficult to get credit, the credit is more expensive when they do get it and there are less people who can afford the monthly payments for a luxury car. Buyers are trading down or postponing their purchase. In the US, used car prices have plummeted, especially for large luxury cars and SUVs that tend to consume more fuel than smaller cars. This means that when clients who leased their cars trade them in, the residual values are much lower than had been forecast at the outset of the lease period. This is bad news for the car companies as it means they sell each leased car at a lower price and they have been forced to write down the value of their leasing books. Leased assets at BMW totalled $20 billion in 2007 and this year they have already increased their risk provisions for residual value risks and bad debts to €695 million.

BMW lent €8 billion to dealers last year and this money must also be at risk as car dealers fight weaker demand and higher operating costs. Pendragon, the UK’s largest car dealership group, recently announced that trading conditions were deteriorating and they have been cutting staff and other overheads to reduce costs. National car sales were down 18.6% in August compared to a year ago. Potentially more worrying, according to their 6 month statement of results Pendragon has in recent years made significant profits from the sale of its properties but the credit crunch has cut a swathe through the UK commercial property sector and this source of revenue is likely to be very weak, if not non-existent, for at least the next couple of years. The dealer’s best business hope is that revenue from parts and servicing continues to be strong but even this is likely to decline as people use their cars less frequently and more people take public transport rather than pay high petrol prices.

The modern day car business is one that is completely reliant on the availability of cheap and easily available credit. It drives almost every part of the business model, either directly or indirectly, and without this finance the industry could go into serious decline if the credit market fails to return to its former glory. The huge growth in the market for the luxury brands is going to reverse as people trade down and the major luxury manufacturers, especially the German marques, are going to see their business model come under severe pressure. It is possible to envisage a luxury car industry that experiences declining demand for years to come as UK consumers pay down debt, face rising unemployment and as a weak Pound pushes up import prices. A ‘luxury’ may once again become just that, rather than something that everyone can afford

Why US debt makes the country vulnerable.

2008-07-24T03:08:00.000-07:00

The US government now has $2061billion of Treasury Bills in circulation. This is effectively the size of the loan it has taken from the rest of the world in order to finance its economy and is one of the reasons that the US Dollar has depreciated so significantly against many other currencies over the last few years. Since 2001 the US Dollar has depreciated 43% against the Swiss Franc and 47% against the Euro. This depreciation has been fairly orderly but there are increasingly important reasons why a disorderly depreciation, or even a run on the currency, could occur.

The largest holder of T-bills is Japan with $592 billion, closely followed by China with $502 billion and the OPEC members who between them officially have $154 billion. However, a lot of OPEC members also own T-bills via proxy that are held in the UK. The high oil price has seen the foreign exchange reserves of these countries swelled with Dollars as oil is primarily priced in US Dollars. China has accumulated their holdings due to the huge levels of trade that are carried on with the rest of the world using Dollars. Japan has long been a keen buyer of T-bills but has recently started to reduce its holdings (by 3.6% in the last year). Asian central banks don’t publicise the allocation of their currency reserves but they hold about $4.35 trillion in total foreign exchange reserves and about 70% of these are thought to be Dollar-denominated. US Dollars and Dollar-denominated assets are held in a wide range of foreign countries, some of whom have strained political relations with the US due to the aggressive foreign policy of the Bush administration and one has to wonder how far they will bend to the will of a financially weak and economically exposed America.

There are several reasons why the US Dollar is exposed to geopolitical and investment risk in a way that hasn’t been seen before:

1) Several countries are now pursuing a policy of diversification away from the US Dollar in their foreign exchange reserves as they are still worried about further depreciation due to the declining economic environment in the US. The Euro is a potential beneficiary or a basket of currencies could be adopted. If everyone starts diversifying at the same time there is the risk of flight from Dollar assets that begins to become obvious to markets and which could cause other investors to panic. Whilst sovereign wealth funds are usually slow to act, they have indicated greater interest in investments in Europe and emerging markets as a way of diversifying their currency allocation as well as their asset allocations.

2) There is talk of the US losing its top investment grade rating and if this were to happen there could be a crisis of confidence in the Dollar. A downgrade would require the US to offer higher interest rates, which in turn is not good for the economy and could cause further Dollar weakness. The US has held a triple-A rating since 1917 but healthcare and social security costs are rising with no sign of a solution to their spiralling costs. The cost of financing military excursions in Afghanistan and Iraq also adds to the problem. America has been spending beyond its means for some time (hence the huge volume of T-bills in circulation) but there is a strong possibility that this strategy may have serious repercussions one day.

3) Several middle-eastern and Asian countries have pegged their currencies to the US Dollar and have had to lower their base rates in line with US rates, in spite of the fact that they are experiencing very high levels of inflation. Qatar is struggling with 14% inflation, Egypt 19%, Dubai 20%, Saudi 10%, UAE 11%. They are not suffering from the same economic woes as the US so interest rates of 2% are totally inappropriate. Middle-eastern countries have been forced to lower rates just as their economies are booming on the back of oil receipts and domestic investment is running at record levels. This divergence in economic fortunes has placed great strains on the Dollar peg and there is a chance that some countries might have to break it at some point, which could be extremely Dollar-negative.

4) The size of its outstanding debt to the rest of the world makes the US vulnerable to pressure in global political matters. If, for example, China wanted to have its way on an important political issue, it could infer that it was going to reduce its Dollar holdings due to lack of confidence in the currency. This kind of declaration would have hugely negative ramifications for the Dollar and the US economy and is something the US would be keen to avoid.

It is this fourth point that I wish to expand on. China is often seen as seen as the main threat to US domination in global politics due to its size, its economy and its military might. It now has a major bargaining advantage in its creditor status. Since China’s rise to prominence as a global economic power, its partial embrace of capitalist culture and its accession to the World Trade Organisation there hasn’t really been a significant dispute with the US. But what if this was to change one day? In the same way that Russia has become more confident and more belligerent as its economic wealth has grown, China could also adopt a more aggressive stance towards the US.

In some ways the economic strength of the US and its influence on the world stage has been sold out from underneath it by the sale of so many Treasury bills. A country such as China, which holds 19% of all the T-bills in circulation, might be able to dictate terms to the US or else it could threaten to sell off its holdings under the auspices of diversification or lack of confidence. Whilst this would mean that the value of all China’s Dollar-denominated foreign reserves were pummelled, it would ultimately survive. However, there would be a run on the US Dollar and it would decimate the US economic system. In one single bound China could overtake the US as the world’s most important economy and as the world’s premier superpower.

If China was to sell its US Dollar holdings at an accelerated rate then the value of the Dollar would collapse and interest rates would be forced up in order to support the currency. High interest rates would almost certainly send the US into a severe recession. It would also likely lose its triple-A credit rating which would exacerbate the problem. A stable currency is essential for any country to attract foreign investment and the Dollar has been propped up for a long time by the continued purchases of T-bills by overseas investors, particularly China due to the size of its holdings. It currently requires $2billion a day to finance the current account and if sovereign wealth funds stopped buying Dollars the deficit could balloon to unmanageable proportions. America’s role as the greatest economic power in the world would be at an end.

Other holders of Dollar-denominated assets such as Japan and the OPEC members would also suffer and they would certainly condemn China for taking such action but are their concerns enough for China to pass up the chance of moving up the rankings in the global economy? Wars have been started for less.

Whilst the chance of an economic attack on the US by China as described above might be considered fantasy, the fact remains that the US has put itself in a position where it is theoretically possible that such a strategy could be carried out and where the very hint of a threat by the Chinese could be extremely damaging. Sino-US relations have never been particularly friendly and the two countries have traditionally been seen as opponents, if not enemies. Maybe the struggle between Communism and Capitalism hasn’t completely disappeared after all and the Chinese have been merely biding their time.

The US has been quite vocal about the way it thinks China should manage its currency but it is not really in a position to dish out advice on a subject in which it is clearly not an expert. The current Bush administration continues to officially support a strong Dollar policy but the reality is somewhat different and they are kidding no-one. Either the US has no control over its own currency or the huge depreciation in the value of the Dollar was what they wanted all along. However, today the US has clearly lost a large degree of control over its currency, and by association its economy, because it has put itself in the position of debtor to China (and to other countries) and this makes the US a riskier place to invest than is widely perceived, regardless of its current credit rating. A rapid sale of US treasuries by China might seem like a black swan event but it is one that is theoretically possible and which can be foreseen. If it ever occurs then you don’t want to be holding US Dollars. Even without any action on the part of foreign holders of US Treasuries, the balance of power has certainly changed and the US has placed itself in a vulnerable position.

Who will pull out of the Euro first?

2008-07-09T05:48:00.000-07:00

Ireland, Spain or Italy? It might sound a bit far fetched to some people but actions speak louder than words. In Germany savers are drawing money out of the bank and demanding that the Euro notes are German Euro notes. Is this a sign that some Europeans are starting to worry about the validity of their currency?

Each member of the Eurozone prints its own banknotes, according to its economic weight, and they are numbered in such a way as to make their country of origin identifiable. According to Ambrose Evans-Pritchard in the UK’s Telegraph newspaper, Germans are avoiding notes with serial numbers from Italy, Spain, Portugal and Ireland, instead demanding notes with the German numbers that start with an ‘X’.

It may seem unusual to still think of the Euro as a combination of different currencies but the same approach is applied to the government bonds that are issued by each country in the Eurozone. For instance, 10 year bonds issued by the Italian government are yielding 5.034% compared to 4.422% for German 10 year bonds. French bonds are offering just 4.636% compared to 5.089% for Greek bonds. It is the financial strength of these countries that effectively combine to underpin the stability of the Euro currency but there are clearly some variations in the governments doing the underpinning. However, a default on interest payments on government bonds would have a devastating effect on the currency and it is unlikely it would be allowed to happen in the Eurozone, the ECB would most likely step in.

But in the same way that investors are applying different ratings to government bonds from different issuers, German consumers are now applying the same approach to bank notes from different issues. In a world where currencies are no longer backed by hard assets such as gold, and rely completely on public confidence, it is not inconceivable that one country’s people might panic and stop accepting notes that are issued by another country. It might be wrong to do this, purely as a result of a lack of understanding of how the Euro is supported by the combined strength of the Eurozone members, but crowd mentality is a powerful force and if people think they are at risk of losing all their money, they will react to save their skins. A run on the notes of a specific country is not totally inconceivable.

The most likely trigger for a run on a currency formed through monetary union is if the chances one country dropping out were to increase significantly. There have been some weak rumours already about Italy dropping out of the Euro but nothing that has caused a tangible effect. However, the economic problems that some countries are experiencing are only going to get worse and investors need to be looking ahead. We could be on the verge of the greatest stress test the Euro currency has ever undergone during its short life.

Over the past few years there has been massive expansion of the financial system in Spain, Ireland and Greece. Low interest rates, combined with a big increase in the number of available financial products on offer such as mortgages and personal loans, has propelled a huge and unprecedented take up in credit in these countries. Borrowing has been available on a scale never seen before. Effectively the interest rate set by the ECB was too low for these high growth countries, having been kept down to support the much larger economy of struggling Germany, and this fuelled a boom in construction, housing and consumer spending.

However, higher inflation and higher lending rates brought about by the credit crunch have turned off the tap of cheap and easy credit and this is causing the economies of the PIGS countries (Portugal, Italy, Greece and Spain), along with Ireland, a great deal of pain. These countries could now do with lower interest rates to help their rapidly-slowing economies but the ECB has to focus on the bigger picture and is compelled to fight high inflation and to take into account much better growth in Germany.

An economic recovery in Germany couldn’t have come at a worse time. There has been a two-speed Europe for some time now but the players have recently changed places and it is the former growth stars that are now in dire need of lower interest rates. In the past, at times of severe economic weakness, a country always had the option of lowering interest rates, just as the US has done. However, even though Spanish GDP growth is expected to more than halve this year and Spain will struggle to avoid recession in 2009, it has no option but to accept the interest rates set by the ECB. The Italian economy is also being crippled by a strong Euro and in pre-Euro days it would almost certainly be considering either lowering interest rates significantly or devaluing the currency.

The real question is, how bad will things get for these countries that are suffering from a huge property crash, a sharp drop in consumer spending and declining demand for their exports? Will political pressure to do the right thing for the country be stronger than the desire to remain as part of the single currency? Many people already blame the Euro for the price rises they have experienced over the last few years, rightly or wrongly, and would probably be keen to see it broken up. If property prices keep falling in Spain and unemployment keeps rising, it will be very difficult to stomach more interest rate rises that are designed to keep external inflation under control, especially as 90% of Spain’s financial borrowing is on variable rates.

If the economy in Ireland or Italy is struggling under the weight of a strong currency and high interest rates, how long will it be before a politician latches onto the idea of proposing a swift exit from the Euro to boost jobs and production, to revitalise the home economy? This might seem like a narrow-minded and short term policy to pursue but you can see how it might be very popular with an electorate who are feeling betrayed by Europe and who blame the people in Brussels for their hardship.

In reality, it might not even need to go that far before the Euro is put under pressure and starts to weaken of its own accord. A serious threat to its stability, with the risk of one departure being followed by others in quick succession, would be enough to undermine confidence in the currency and to see a sharp move in its value against other currencies. Whilst this would ultimately be damaging for those invested heavily in Euros, it could also present a very interesting opportunity for those Euro-based investors who were ready and waiting for such a move. George Soros made over $1billion when the Pound was forced out of the Exchange Rate Mechanism in 1992. Some people will also do very well if a currency pulls out of the Euro today, it’s simply a case of watching and waiting for the signs and ultimately being open to the possibility that this could happen. Even though several European countries could go into recession in the next couple of years there is always money to be made by investors if they think ahead and prepare for possible opportunities.

Investing in bonds in an inflationary environment.

2008-06-25T07:59:00.000-07:00

With inflation figures reaching worrying levels in the US, UK and Europe, not to mention most emerging markets where they look as though they are getting out of control, this might seem to be an odd time to be looking at bonds as an investment. Index-linked bonds have been popular for some time now because they protect investors from future inflation rises but they don’t offer very compelling value at current price levels. However, fixed rate bonds now look appealing.

It has been difficult to find good value investments for some time, even though stock markets have fallen in recent months. The worst hit sectors of the main stock markets are financials and construction stocks, some of which have gone bust or been rescued by the State, such as Northern Rock and Bear Stearns, and where share prices have fallen over 60% in other cases. It is debatable whether these stocks represent good value because we are probably not near the end of the credit crunch yet, with problems in Europe and the UK still only just starting to unfold, and the property market is going to have to fight a lack of buyer confidence plus a huge oversupply in some areas for several years to come. They are cheap but for a good reason and they could struggle to grow earnings for some time.

An investment in bonds at a time such as this is based on the belief that inflationary expectations are priced into current bond yields and there are many bonds that offer what looks like good value, in a world of rapidly rising prices where value is difficult to find. It is also possible that the recent inflation scare has caused prices to overshoot on the downside.

Bonds also offer good visibility, if we stick with investment grade bonds, as they are rated for security (unlike stocks) and we can usually assume that the capital will be repaid at maturity if the company doesn’t go bust or default on its debts. In the event of a serious problem appearing out of the blue there is also a better chance of getting paid if you are holding bonds compared to shares as you are higher up the list of creditors.

To reduce the risk of default, or its effects on a portfolio, you can:
1) diversify across a number of different bonds
2) stick to investment grade bonds only
3) focus on blue chip companies.

By doing this we reduce the risk of loss from default as much as possible. This provides a great level of security, if we can assume that capital will be repaid at maturity. We can add another level of security to the investment by choosing securities with a short to medium term maturity date such as a minimum of 2 years up to a maximum of 5 years. This means that we could probably hold a bond to maturity if inflation does get out of control and bond prices drop even more sharply from here.

However, current investment grade corporate bond prices provide us with a margin of safety. There has recently been a reversal of interest rate expectations in the US, EU and UK which has seen bond prices fall sharply and yields have moved up to very interesting levels. Many corporate bonds are trading at below par and are offering yields more than 100 basis points above base rates.

Here are some examples:

Bayer AG 2012 €. Yield 5.79%.
Unilever 2012 €. Yield 5.29%.
Gaz de France 2013 €. Yield 5.44%.
Tesco 2010 £. Yield 6.27%.
AT&T 2012 US$. Yield 5.20%.

Since March this year, less than 12 weeks, the Gaz de France bond has seen its yield rise from 4% to 5.44% and the Tesco bond has seen its yield rise from 4.7% to 6.27% over the same period. In my opinion, neither of these companies are likely to default before the bonds reach maturity yet they are now offering very interesting yields above base rates.

A portfolio of investment grade corporate bonds at these prices can boost returns on money that was previously sitting in cash (in very short dated maturities) and could provide a capital return if economic growth slows more rapidly and starts to become the main focus of central banks and their governments once more (in longer dated maturities). If investors feel the chance of this happening is significant then they can also buy much longer dated bonds that will rise more if interest rate expectations weaken. A staggered portfolio will provide the best risk/reward ratio. These bonds should remain fairly liquid and will also have defensive properties if stock markets fall further or if the geo-political situation in the Middle East worsens. If the price is right, bonds can be worth buying in an inflationary environment.

The Domino Effect

2008-06-12T03:29:00.000-07:00

If someone offered you the chance to have your future salaries right now, rather than having to wait until you had earned them, would you take them? If you were told that you could spend this money today and not have to wait for all the things you wanted to buy, would you leap at the chance? Even if you were told that you would be charged for this opportunity, would it still look like it was too good to miss?

This is effectively what happened to people everywhere who found that they could borrow large sums of money much more easily than they’d been able to in the past, and ordinary people in many countries around the world took up this offer and started spending their future earnings. It is this extra spending capacity that has largely powered the economies of the western world for the past decade. The average person has seen their spending power explode, and they have been shopping like a lucky lottery winner.

The BMW 3-series now outsells the Ford Mondeo in the UK, as buyers have traded up. It has become common place to spend over £1000 on a plasma screen, compared to a few hundred pounds that we used to pay for a television. Designer clothes are no longer the preserve of the wealthy and people have been able to copy the look of their favourite celebrities. Harvey Nichols, the ‘international luxury lifestyle store’, has found new custom in places outside of London, such as Leeds and Manchester. Shopping in the UK and the US has changed in less than a decade, all because of the instant boost to spending power that credit has provided.

This was always going to be a one-off hit, a step increase in spending rather than a gradual increase made possible due to rising productivity, innovation or plain old hard work, and therefore it was never going to be sustainable indefinitely. Eventually the money tap was shut off as confidence in the concept diminished and this left a stark contrast between the before and after situations. Since the dotcom bubble popped there has hardly been any let up in the increased spending of people in Europe, the UK and the US. Even in the mini recession that the US experienced after 2001 US retail sales kept growing. “Never under-estimate the resilience of the American consumer” is what they say.

For the last few years incomes have grown very gradually in the developed economies of the west, rising slightly faster than the official inflation figures. If you believe the official statistics of 2-3% inflation then real incomes have probably increased by 1-2% per year. If you don’t believe the official inflation figures (and many people don’t) then you would see that real incomes for many people, depending on their spending patterns, have probably decreased in recent years, meaning that people have actually become poorer in terms of their earning power. But not in terms of their spending power or their ability to raise money. Rising property prices have made people feel wealthier and have enabled them to borrow money more easily against their assets. They have ‘money’ but it is tied up in their homes so they have to borrow from banks etc to release it. Technically, even though they are deemed to have this money, they have to pay someone else (in the form of interest and other loan fees) in order to be able to spend it. Is this real wealth if you have to pay someone else to access it? Isn’t it still just borrowing someone else’s money?

In any event, borrowing has increased massively in all parts of our daily life. Loans are now used regularly to buy cars, televisions, stocks, holidays, even plastic surgery. Almost anything can be bought on a credit card and, whereas in France you have to buy a credit card from your bank, in the UK they are positively throwing them at customers. Or at least they were until the credit crunch arrived. Lenders have started to realise that offering people such huge spending power with little regard for their ability to repay the debt could be bad business practise, and now new credit card approvals have diminished significantly and some card providers have cancelled the cards of their existing customers. Lending volumes for car finance, personal unsecured loans and mortgages has shrunk significantly.

The end of the credit boom has been accompanied by the rapidly rising cost of living for many people as food and energy costs have shot up at the same time as lending rates. People are finding their disposable incomes are shrinking rapidly and are struggling to maintain their former lifestyles. In the US credit cards are increasingly being used to pay for bare necessities such as food because more people are finding it difficult to make their salary last the entire month, and this has recently started happening in the UK. Traditionally supermarkets are usually busiest at the start of the month, shortly after people have been paid, but Walmart has said that they are finding their stores are less and less busy towards the end of the month and this monthly decline in spending is starting earlier and earlier. Consumers are also making a conscious effort to use their cars less because the cost of a tank of petrol is starting to look a bit scary. Everyone is cutting back.

This leads me on to the domino effect that we are seeing around the world, and that we will continue to see for some time. The credit crunch was triggered by defaults on sub-prime mortgages but this is only the tip of the iceberg, the iceberg being the huge amount of debt that has been taken on by consumers. Defaults on US sub-prime debt caused panic in credit markets and pushed up interest rates or caused financial institutions to reign in their lending practices. Higher interest rates are bad for new homeowners and existing homeowners trying to refinance, something that has become commonplace. Some homeowners don’t immediately want to refinance but they are on short-term fixed rates that are coming off very low teaser rates and they are being reset at much higher rates, forcing the borrower to take some form of action as their repayments start to balloon. It isn’t just sub-prime borrowers that are finding higher lending rates a problem.

Higher rates and a lack of available borrowing have hit many areas of the real economy. People are handing the keys of their house to the lenders and walking away if they can’t make the payments on the mortgage and they have gone into negative equity. Defaults on car loans, credit cards, home equity withdrawal loans and personal loans are all rising and could be a new wave of problems for the financial markets to rival sub-prime mortgages. Borrowing against certain smaller cap stocks has been withdrawn or loan-to-value ratios have been decreased for those trading on margin.

The commercial property market in the UK has experienced a large drop in valuations as consumers slow their spending and job losses start to look more likely, reducing the demand for shopping centres and office blocks. The speculative element of this market has almost been wiped out as investors find it difficult to raise finance. The same thing is happening across much of the globe.

The dearth of mortgage products, coupled with reduced ability to afford monthly payments for luxuries, has seen a big drop in demand for overseas property. An area such as the South of France where more than half of property purchases have been made by foreigners is hit particularly hard as supply suddenly begins to outstrip demand. It almost becomes a downward spiral because the lack of demand from new buyers starts to hit valuations of existing properties and once prices are falling, as they are in Spain, France, Ireland and the US, people realise that property prices don’t only go up. Falling property prices and rising interest rates are a killer combination for a society raised on property ownership, such as the UK, and owning a second home starts to look like an expensive millstone around the neck.

Risk aversion in financial markets has also caused big swings in exchange rates and has seen safe haven currencies appreciate against less fundamentally sound currencies. One place this has important ramifications is Eastern Europe where many home buyers have taken mortgages in low-yielding Swiss Francs, to reduce their interest payments compared to borrowing in the local currency. 85% of household and corporate borrowing in Latvia, for example, is in foreign currencies. 80% of mortgages taken out in Hungary in 2007 were in Swiss Francs. The problem comes when the exchange rate moves and the Swiss Franc appreciates. This effectively increases the size of the loan when converted back into the home currency and at some point the banks start to worry when the size of the loan moves closer to the value of the property against which it is backed. I wouldn’t be surprised if some lenders are attempting to postpone having to value their loan-to-value ratios on mortgages they have given because they could be forced to call in those loans where the equity in the property has been wiped out. Foreign currency mortgages were always considered high risk but they appear to have proliferated in some Eastern Europe countries as immature financial service industries expanded at breakneck speeds and we could still see a serious issue emerge for those lenders who are the big players in these markets.

The domino effect has seen sub-primes losses spill over into prime mortgages, credit cards, car finance and personal loan losses. It has hit residential property, commercial property, holiday homes, private equity borrowing and corporate lending. The impact in the property and financial markets has also had a knock-on effect on spending on the high street and is affecting every sector where people spend money. After years of very low consumer price inflation alongside high asset price inflation, we are now seeing the opposite: high consumer price inflation and asset price deflation. This is not good news for countries such as the UK and US where domestic consumer spending makes up the bulk of economic activity.

The domino effect is also evident across borders because problems in the US have had huge impacts in other countries. Swiss banks have written off billions from their investments, the Spanish property market has been left with a massive oversupply of stock it can’t shift, the Irish stock market has lost one third of its value since last summer because of its focus on financial and construction stocks and the UK is facing a crisis of confidence in the economy because the mortgage market has dried up.

According to some economists, Asian and Middle Eastern countries appear to have decoupled from the problems elsewhere but many of these countries have currencies that are pegged to the US Dollar. Prices are rising at above 10% per year in Saudi Arabi, Qatar and the UAE. Even with inflation raging at danger levels, these countries have been forced to lower interest rates as the US has done, even though their economies have been overheating. One wonders how long this anomaly can last before something snaps.

The financial world today is an incredibly complex array of different flows of money, it is all far more connected than people realise. Pensioners in Norway were shocked to find their retirement funds had been invested in US sub-prime mortgages. The residents of Vallejo, California, were definitely surprised when their town filed for bankruptcy in May this year, blaming a big decline in housing-related tax revenues. Confidence in property markets has taken a knock all over the world as investors have been painfully reminded that property prices are not a one-way bet. A common phrase in the financial world is “when the US sneezes, the rest of the world catches a cold.” This is still true today and the only cure for a world hooked on credit is for it to go ‘cold turkey’. Painful, but almost certainly necessary.

Inflation, deflation, stagflation.

2008-05-14T06:32:00.000-07:00

Food prices are rising, property prices are falling and economic growth is stalling. The ultimate balance of these factors will determine whether the global economy will be ravaged by surging prices or whether the economy will slow sufficiently to depress asset prices for years to come. Currently we appear to be in that state of limbo known as ‘stagflation’, an extremely devastating condition that is bad for everything and everyone.

Prices are rising for many agricultural products as demand increases from the rapidly growing economies of India, China and other developing countries such as Brazil and those in Eastern Europe. As people in these countries become wealthier they tend to progress from a subsistence diet (rice, potatoes etc) to a more protein based diet (meat, fish etc) and that requires more food for animal feed. The overall demand for agricultural products increases and that pushes up prices. Whereas this is inconvenient for us in the West it is positively disastrous for those living in poverty who can’t afford the higher prices. Some countries have seen food riots and have started hoarding their own agricultural stocks rather than trading it. India has banned futures trading in several food commodities to reduce speculation.

The oil price has hit a new high and has risen over 900% in the last 10 years (from $12 in 1998 to $125 today), again partly driven by demand from developing countries but also helped along the way by speculators around the world who can now easily buy derivatives based on the oil price. Gas and electricity prices have also increased, uranium for nuclear power has shot up, even the price of coal has made a comeback. Prices of metals have been rising sharply for several years now because the supply/demand balance has remained tight, pushing up the price of everything they feed into.

In spite of rising prices in these raw materials, inflation for many people in the West has been low for years, often around 2-3% according to official government figures. However, most economists take those figures with a pinch of salt because they tend to exclude certain volatile items, depending on which country’s figures you are looking at, such as food, oil and even ignoring mortgage payments. The official (core) figures have tended to give prominence to goods that have seen falling prices such as clothing, electronics and airfares. The difference between these goods and those that are seeing rising prices is that they are usually non-essentials and they have been one of the main beneficiaries of the extra money that the financial system has created in recent years. As people have gone out to ‘shop til they drop’ they have been buying these goods and haven’t had to worry very much about the rising prices of essentials such as food and warmth. It is families and pensioners, the people who spend a greater proportion of their income on these essentials, that have experienced much higher rates of rising prices than someone who shops regularly for leisure items.

Inflation takes time to feed through and now it is starting to register for a greater number of people in the West. This pushes up demands for higher wages which in turn fuels higher inflation expectations. Rising credit costs, coming after a decade of splurging on debt, is starting to get worrying and people are feeling their finances being pinched. They can cut back on shopping for non-essentials but they struggle to cut down on electricity, petrol and food. If prices of basic goods and services keep rising then they find that their ability to control their spending is diminished, it is taken out of their hands.

Rapidly rising inflation is a tangible and noticeable problem and as people cut back on their spending of non-essential or luxury goods this tends to have a negative effect on the wider economy. Economic growth is slowing or becoming negative whilst prices of many things are still rising. This is stagflation and is difficult for central banks to deal with effectively. They can’t easily cut rates to stimulate growth because this then exacerbates inflation. If they raise rates to cool inflation then they risk choking off any remaining consumer confidence. In reality most governments will make a decision to prioritise the fight against inflation or stopping economic decline and they will either lower interest rates (as in the US) or raise rates (as in Australia) accordingly.

Having experienced inflation and stagflation, the next big worry is deflation. There are some who believe that lowering interest rates to stimulate economic growth could be ineffective at this stage in the economic cycle. Most people would agree that it was low interest rates that created a credit bubble in the first place, making credit cheap and easy to obtain, leading to an unsustainable situation and too much leverage in the financial system. Whilst it could be regarded as reckless to lower rates again, it is quite likely that lower rates will no longer provide the incentive to borrow and invest once more as many people and countries are still heavily indebted, and there has also been a huge shift in emphasis on credit quality by lenders regardless of the cost of money (as illustrated by the credit crunch).

On the way up through the cycle extra financing provided greater purchasing power which in turn pushed up prices, as witnessed in the markets for commodities, property, art and luxury goods. An attempt to sell a diamond-encrusted skull for $50m could only happen at the top of an economic boom. Conversely, a retraction of spending power (due to less credit) coupled with a greater focus by lenders on securing their borrowing is likely to see prices pushed lower. We are already seeing this most prominently in the property markets of Spain, Ireland, the UK and the US where prices are coming down. In simple terms, prices are falling and people expect them to be lower in the foreseeable future, a view that is likely to be applied to a growing number of sectors such as consumer electronics, cars and furniture. Anything that is related to real estate or anything that is considered discretionary is going to come under severe price pressure as more people find they have less disposable income. And as consumers find themselves under more financial pressure they are going to start saving money again and paying down debt, not spending it.

This is where Japanese history becomes interesting and it won’t just be Ben Bernanke who will be looking closely at the Japanese experience of the 1990s. This is often known as the Lost Decade because Japan experienced damaging deflation from the beginning of the 90s after the twin bubbles in the stock market and real estate market burst, causing a downward spiral in asset prices. Japanese people stopped spending money, afraid of the consequences of doing so and conscious that if they postponed their spending decisions they would probably find prices lower in the future anyway. This attitude is very bad for the domestic economy and Japan proved that interest rates as low as zero are not necessarily going to encourage people to borrow and spend again, not once they have already had their fingers burnt. Economists usually say that the problems in Japan were different from today’s problems but years of working in the financial industry teaches you that the financial whiz kids can always come up with new ways to lose money and no two financial disasters are exactly the same.

The world has just been through a massive expansionary phase in money creation within the financial system and this has fed through into the prices of stocks, commodities and real estate. The long-term global bull market in equities probably ended in 2000, the bull market in real estate probably ended in 2007 and we have yet to see what happens to the bull market in commodities. Whilst these market peaks have not occurred simultaneously they can’t be dismissed and the similarities with the Japanese problem certainly deserve some respect from investors and central bank governors. We might be experiencing inflation, we might be facing the prospect of deflation but what we know for sure is that we are currently in the grip of stagflation and it is this which is possibly the scariest because it takes control away from the policymakers and reduces their ability to act. If we are on the brink of a major step change in the pace of the global economy then it is likely that one of these forces will assert itself and if it is deflation then we should be worried, we have already seen what that did to Japan.

The Sad Tale of the Fall of the Magic Kingdom.

2008-04-15T00:41:00.000-07:00

Once upon a time, far across the ocean, there was a magical land that was the envy of the whole world. It was the land of the free, the home of capitalism, where anyone could become rich through hard work, and it was the world leader in business productivity and financial innovation. The economy became the largest in the world and led where others followed. Its stock market set the tone for the world’s investors and its currency took over from gold as the ultimate store of value. But one day all this changed and slowly a kind of rot set in that began to eat away at all the good things that had been achieved.

Some would say that the country got too big for its boots when it tried to ‘persuade’ other nations to adopt its version of a political system. Others say that putting numbskulls in charge was never a great idea, especially where huge sums of money are involved. But for the casual observer, it seemed that the country simply started to struggle to live up to its own reputation and the people had started to paper over the cracks that were appearing in the system.

The rich got richer and the poor got poorer, although they didn’t always know it. Those at the top of the tree devised a way for those at the bottom to continue spending more without actually having to earn more money, thereby postponing the day when the gap between the haves and the have-nots grew untenable, the day the people would rise up. For many years the popularity of television had acted as valium for the masses, keeping them happy and occupied for several hours a day whilst at the same time encouraging them to spend their money through the use of commercials, thereby fuelling the need to work and earn money. However, as time passed, the average person felt a stronger desire to emulate the people they saw on the tv, the celebrities with the expensive clothes and the luxury houses and cars. They started to spend money like it was going out of fashion, the mall became a home from home and for a time people were able to make easy money from get-rich-quick schemes such as flipping condos or trading tech stocks during the dotcom boom.

However, even that route to riches turned out to be a get-poor-quick scheme for lots of people and something else was required: cheap and easy finance. This time there was no need to work longer hours, get a second job or even, heaven forbid, to save up for things. It was now possible to buy that new car, to get that second home or that hot tub for the patio, and you didn’t need to have the money to pay for it because people just gave you the money! You didn’t even have to prove that you could pay back the money.

This truly was a magical kingdom. Some people say that this new found ‘wealth’ made the inhabitants of this land lazy and with the exception of the ipod they hadn’t come up with a good idea since the hamburger. Empires aren’t built on trendy music devices alone and pretty soon it became apparent that there could be a flaw in the economic miracle that had been driving the economy for the past few years. As soon as someone realised that there could be a flaw then that possibility alone was enough to make the bankers nervous.

The heroes of the financial world had brilliantly sold the concept of ‘buy now, pay later’ but what if the people couldn’t ‘pay later’? What if they suddenly found that certain household expenditures were rising and that they were precisely the things they couldn’t cut back on such as food, electricity and petrol for the car? They had already bought the new car, they had to fill it up and use it otherwise it would make the purchase look stupid, and besides, no-one ever went anywhere without their car, it was clearly a sign of poverty or delinquency. It was going to be difficult to cut back on food because you tend to get hungry quite quickly when you weigh 23 stone and it was going to be difficult to use less electricity, having just bought a huge plasma screen to go with your 7-speaker surround sound system.

As the bankers got more concerned they stopped lending money because they decided that they might need more of it for their shareholders. They cut back on the easy lending, raising the eligibility criteria for all types of credit, and they then paid out increased dividends to their shareholders. In the meantime the kingdom’s central bank had started offering virtually free money and was taking virtually any kind of assets as collateral for loans. This was a great opportunity for the banks to borrow money very cheaply once more, they could offload a load of rubbish assets they had taken on after a boozy lunch one Friday and maybe they could even start up the whole lending merry-go-round again. After all, the king wouldn’t complain if people were spending more money. He had actually cut taxes and returned some of the money the people had only recently given him, in the hope that they might spend it on more tvs and cars.

One day a little boy came to the king and asked him “What happens when the money runs out?”. The king replied “We print some more!” The king thought ‘This economic management malarkey is simple. If we need more money, we just print it and buy things with it. Everyone knows our currency is the safest thing in the financial world so if we print more of it then the world will be an even safer place. Stands to reason.’ And that is what they did, they borrowed money from those who were stupid enough to lend it to them and they printed more notes when it needed paying back. What could be simpler?

There were rumblings in the newspapers and the tide started to turn when the people noticed that they weren’t getting as much for their money as they used to. They were vaguely aware that their salaries had hardly budged in 5 years but that didn’t matter so much when they could still buy things on the never-never. However, now the punchbowl had been removed and when they tried to borrow more money they were told that ‘they couldn’t afford it’, a phrase some of the older members of the community remembered from their distant past. At the same time the 1% introductory interest rate period on their jumbo mortgage had come to an end and they were surprised to find that the rate had now jumped to 7%. They were shocked that their repayments had now also become ‘jumbo’ sized. Many people were in dire straits and when they asked the government to help them out they were told that there wasn’t any more money because it had been lent to the bankers who, it turned out, were old college chums of the king and needed it to pay their shareholders.

The inhabitants of the magic kingdom were unhappy because the magic had disappeared. The only ‘wealth’ they had left was tied up in their homes, which they couldn’t sell, and more people were slowly starting to lose their jobs in greater numbers as the economy slowed. With no savings in the bank (savings are what old people have and who trusted banks to look after them anyway?) some people just popped the keys to the house in the post to the mortgage company and walked away. The mortgage companies that held the loans against these formerly-safe assets started panicking. They weren’t in the real estate business, they were in the finance business. They didn’t want to own homes, they just wanted their money. They auctioned off what they could and told their investors that the unforeseen circumstance of more than one person defaulting on their mortgage at the same time meant that they couldn’t raise as much money from asset sales as they had thought. Many of them suddenly found themselves unable to continue in business.

By now the long economic miracle was starting to look a bit like a sham. True, a few young people running hedge funds had gotten very rich and lot of people had very big tvs, but generally it appeared that many people were worse off now than their parents had been. Some people even questioned if this could be considered to be progress and, if not, what had gone wrong? Some people are started to question an economy that is 70% reliant on money going round in circles and some people started to get a distant feeling that they should be trying to develop something useful to sell to the world rather than just shopping all the time. The wealth of the last few years had turned out to be an illusion created by a bunch of friendly bank salespeople, many of whom were now facing unemployment themselves, but who had inadvertently handed out a lot more IOU slips than they should have.

The future looks bleak for the magic kingdom. The printing presses are still churning out the banknotes but they aren’t as popular as they used to be and those unhelpful chaps at OPEC refuse to lower the price of oil. The war on foreign soil that was supposed to secure a future oil supply and unite the nation against a common enemy has become a farce, has tarnished the good reputation of democracy and is costing a fortune (and still no sign of oil). Whilst sales of superyachts are still booming, the average working man has run out of money and out of credit and everything is getting more expensive. The economy has been propped up by spending on defence and on construction for a very long time but with house prices setting new records for declines every day there doesn’t seem to be an obvious driver of economic growth to take over. The kingdom needs a miracle, and ideally one that isn’t based on shuffling paper money around. This is one fairytale that is unlikely to have a happy ending.

The Liquidity Bubble.

2008-03-25T05:08:00.000-07:00

The recent problems the world is experiencing in credit markets are directly attributable to the massive injection of liquidity caused by the lowering of interest rates around the world. Why are central banks using the same tactics now if they already know what problems widespread availability of easy money can cause?

Since the start of the credit crunch last year the world’s central banks have been printing money like it has gone out of fashion and lending it to the very bankers who can be blamed for the crunch. This month the Federal Reserve announced that it would lend primary dealers in the bond market $200billion in Treasury securities and accept triple A-rated mortgage-backed securities in return, something the ECB has been quietly doing for Spanish banks for some time now. The Fed also provided a $30billion credit line to JP Morgan to enable it to purchase Bear Stearns. In August last year the ECB injected 94.8€ billion in overnight money. The Bank of England has effectively provided $48billion of state aid to support the British bank Northern Rock. In addition to all these injections of money into the financial system, and plenty of others, the Federal Reserve has now lowered interest rates to 2.25% and the yield on the 10 Year US Treasury has come down to 3.33%.

The aim is to ensure that financial institutions who require funds for refinancing, such as lending institutions, hedge funds, private equity houses, banks etc, have access to the kind of funds their business models depend on, and which, when left to market forces, have disappeared. The US is supposed to be the greatest champion of the freedom of market forces and ‘laissez faire’ macro-economic management but when it’s own house is in trouble then the state has to intervene. This is understandable, even if state intervention is usually more negative than positive, but the fact that the immediate problem is being solved with the medicine that poisoned it in the first place makes it seem a little hypocritical.

The credit crunch was initially a problem that only affected niche areas of the financial system but its effects have spread much further. Banks are reluctant to lend money to each other because 1) they might need it themselves and 2) they are worried about getting it back. This general fear about lending has meant that all asset-backed securities are now looking far less attractive and the assumed liquidity of such assets is now much less than it was a year ago. This means that all mortgages are now looking more risky, as housing markets topple over around the world, and even loans backed by assets such as cars are being re-rated.

For the average person this means that it is now harder to meet lending criteria when trying to obtain a mortgage, or even to refinance a mortgage that is coming off its initial low fixed rate. Even though base rates have gone down in some countries, actual mortgage rates have gone up and many mortgage products have been removed from the market. In addition, the loan-to-value ratio has shrunk, which means that buyers (and those refinancing) have to provide a larger deposit or piece of equity in order to qualify. With house prices still very high by historical standards, many people will struggle to find the extra funds, especially after the spending binge of the last few years and when faced with rising food and energy bills. Volume in the mortgage market has shrunk dramatically and is likely to shrink further.

The tightening in loan-to-value ratios has also started to affect lending to investors and is putting downward pressure on certain types of stocks. At least one broker in the City has raised the margins it requires for investors in CFDs of small companies and this has meant a number of margin calls are now being made, causing investors to sell down their holdings. Hedge funds, who rely on leverage to achieve above-average returns are also feeling the squeeze as their lending costs are raised and their lending facilities are reigned in. Private equity deals have almost ground to a halt as banks question the ability of venture capitalists to finance interest payments out of falling earnings.

The financial system obviously faces huge problems that need addressing but is the injection of billions of Dollars the best answer? Low interest rates and a large increase in the money supply after the dotcom bubble burst led to a massive increase in lending by financial firms, governments and individuals until it got to a point where it seemed everyone had plenty of money to spend, none of it theirs. Is this what the central banks are trying to achieve once more?

However, I would say that the problem this time around is not one of lack of money, it is more to do with fear of being over-extended against over-priced assets. Even though they are prepared to take your house as collateral, the banks don’t really want it because they can’t sell it any easier than you can. We know this because this scenario has played out before in the UK and Japan in the last property crashes but lending institutions seem to have forgotten. However, also like Japan, an injection of liquidity can be useless if people simply don’t want to spend money and prefer to save it. Japan dropped interest rates to zero (which in itself added to the liquidity bubble in the rest of the world) but it didn’t encourage the Japanese to borrow and spend. When the Bank of Japan finished lowering rates to zero it effectively exhausted its greatest weapon and we could see the same thing happen in the US today. The effect of negative real interest rates is unlikely to have the same positive affect on borrowing and spending that it had after the dotcom bubble popped. And if it did, and people started borrowing and spending furiously once more, what would happen when that bubble popped?

This is not a sustainable strategy. It undermines the currency, having destroyed the Dollar’s credibility as a solid currency, and it just exacerbates the real underlying problems and pushes them forward until it is no longer possible to postpone the inevitable. We could well be at that stage already because there would appear to be little chance of consumers increasing their borrowing significantly in the face of rising unemployment (in the US only, so far) and higher prices (everywhere). Flooding the financial system with money might only weaken the currency further, making the US in particular a less attractive place to invest, and if it simply serves to bail out the bankers and hedge fund managers who have made poor investments then the longer term consequences for the US could be much wider.

We don’t try to help drug addicts with the problems of their addiction by giving them more drugs. We make them go cold turkey. Central banks need to face up to reality and stop giving people cheaper borrowing. What the world’s consumers and investors need now is a bit of cold turkey.

Return of the bear market.

2008-03-20T09:59:00.000-07:00

A few years ago several economists suggested that the peak of the markets at the end of the dotcom bubble were the top of a long term bull run going back nearly two decades and that we were about to enter a long term bear market. This theory looked fairly realistic for a couple of years as most stock markets headed down and lost a lot of value. However, the rebound in 2002/2003 signalled the end of that particular bear market and the start of a new bull run. Some people labelled this as a bear market bounce but the longevity and the strength of the bull run outlived that theory and markets rose to their recent peaks at the end of 2007.

The bubble in equities collapsed in 2000 and whilst there was a bear market for two years there was also another bull run going on in property. This parallel boom helped retain confidence amongst more experienced investors and also helped most countries avoid recession as it helped drive household wealth creation and activity in the construction industry that fed through into the wider economy. There is even some debate about whether or not the US really went into recession when the stock markets collapsed. So the bubble in equities was followed by the bubble in property, both of which have been driven by the availability of financing that can add leverage to any deal and make it bigger and better.

Until now. The freezing of the credit markets has effectively cut off the flow of money going into both property and equities and the main focus today is not on how to invent new ways to finance deals but on how to get your money back and avoid further losses. The element of fear has returned to investment markets after a prolonged absence and the knock-on effects of this change in the availability of finance are so wide reaching that we are seeing a domino effect in defaults beginning with US sub-prime lending and feeding into hedge fund borrowing, private equity financing, auto loan defaults, contraction in credit card issuance and now spreading into prime lending markets. Remember, this is during a period of high employment whereas historically such defaults started to occur as businesses slowed and laid off workers.

We are even seeing market interest rates on mortgages heading in the opposite direction from central bank base rates as the spreads widen at an alarming rate. And after two decades of rapidly expanding household and corporate indebtedness, the last thing the world economy needs is a credit crunch. There have been credit crunches before but this could be a big one.

This leads me onto my next suggestion: the economists who called the top of the multi-decade bull market were right all along. It just didn’t look like it until now. A look at the charts of several major stock markets illustrates certain similarities that suggest we could already have seen the top. (Unfortunately I can’t illustrate the charts here)

My chart for the FTSE100 goes back 14 years and it looks very much as though we have recently seen a double top formation with strong resistance around the 6700 level. The market has recently hit the same ceiling twice, around the level it hit at the end of the 90s, and it has failed to go through that level and its next path could well be down, to a much lower level. The 2000 peak and the recent two peaks suggest significant resistance at this level and viewed over a 14 year period they look like two double tops in a longer market cycle.

Take a look at the German market. The chart of the Dax indicates that the market has twice now hit resistance around the 8000 level and failed to go higher. The French CAC40 shows a similar pattern but the rally didn’t even reach the previous high before starting a downward slide again and the current ‘correction’ is bigger than anything seen since 2003. This chart, if extrapolated forwards, would clearly indicate that the market has failed to reach a new high since the 2000 peak.

The S&P500 appears to corroborate the evidence, even though it seems to have pushed a little bit higher with the recent peak, it certainly isn’t a significant push through the resistance level. The difference between the 2000 peak and the 2007 peak could be attributed to a few days of over-exuberance that pushed it a little higher than before but the long term chart looks very much like these two peaks are forming a double top in a much longer cycle.

Not all stock markets exhibit the same pattern but it does look like some of the most significant ones do show a double top pattern forming out of the peak at the dotcom boom and the peak of the credit/property boom. Normally the next move would be a longer slide to a much lower level of support. Is this likely?

The credit crunch we are experiencing today was preceded by a similar, although certainly not identical, credit implosion in Japan at the beginning of the 90s, after a decade of unprecedented economic expansion and the formation of a huge bubble in both stocks and property. Whilst most people believe that the two scenarios are too different to be totally relevant, I believe there are very significant similarities that could indicate where we are headed today (that I have described several times before and won’t go into again here). My point is, we shouldn’t be too surprised if bubbles in stocks and property that are burst by a severe crunch in the financial system cause a long economic slide in some economies. It’s happened before and there are a lot of signs indicating that it is happening again.

In summary, there are a lot of arguments for a sustained slide in equity markets that may actually only be part of a longer term bear market. There will be plenty of ups and downs along the way but the drivers of the global economy are weakening rather than strengthening. Emerging economies such as China and India could still continue to grow rapidly for many years but a lot of future growth has already been priced into markets and whilst their domestic demand should continue to expand, they will be missing that extra push from overseas export growth. China, for example, is primarily an export-focussed economy and its largest export customers are either in recession or facing a severe slowdown.

The whole financial system needs a good clean out. We need to get rid of excess debt and excess liquidity. The Fed is trying to pump more liquidity into the financial system but the fundamental problems we are experiencing today have been caused by too much money, not too little. Over the course of the next 2-3 years we will see if it really is possible to avoid recession, as the central bankers say we will, but there have been recessions in the past and there will be recessions in the future so if we don’t have one now, after such a false economic boom, when are we going to see one? All the signs of excess that precede a downturn are there and that Japanese scenario is looking more likely every day. I think it will be a miracle if we don’t see a lot more bad news during the next 2-3 years.

How did so many people come to own two houses?

2008-02-18T09:36:00.000-08:00

Since the late 1990s it has become quite normal to own a second home and today there is a massive industry selling holiday homes in wide range of exotic locations around the world. According to the Office for National Statistics, around 2 million Britons now own more than one home, many of which are in the UK but there is also a growing number abroad, with sales being driven by overseas property features in the media and the expansion of budget airline routes.

If you cast your mind back you can probably remember when it become the norm for the majority of people to own their own first home rather than to rent. It wasn’t that long ago and it was a normal progression that enabled people to borrow money more easily and to make the jump from renting to owning. Even though financing became more widespread, people still had to save up for a good deposit and for everything that went in the house. Today, no-one saves money anymore and everything is bought on the never-never (as it used to be known). During the last decade the world has changed as far as money and wealth are concerned in the UK.

In the long run it makes sense to own a property rather than to pay money in rent each month because a portion of each mortgage payment usually goes towards paying down the debt and therefore the capital in the property accumulates. Getting on the housing ladder has become a rite of passage today, not just an aspiration.

During the last decade things have changed enormously. Whereas 10 years ago it was only relatively wealthy people that owned a second home, it has now become a realistic possibility for millions of ordinary people, as illustrated by the explosion in adverts for holiday homes as far as away as Thailand and Canada. Bearing in mind that the average real income (i.e. accounting for inflation) has hardly risen at all during the last decade, how is it that so many people now have two houses without having any significantly higher disposable income?

If you ask the average person in the street what the currency is in Bulgaria or how to say Hello in Romanian, they won’t have a clue. If you ask them whether or not Bulgaria is considered a good place to own property as an investment, I bet many Brits will be able to express a view. There are so many developers promoting holiday homes in eastern Europe that British people now consider it desirable to own a luxury apartment or villa in what is still considered to be a third world country. The advertising does a very good job of selling a lifestyle that is often far removed from the wider reality in these countries but part of the appeal is that property in many eastern European countries is very cheap compared to the UK. However, in addition to the image buyers have of themselves sipping champagne on their terrace as the sun sets over the countryside, I would argue that the main appeal is the potential for capital growth.

It is amazing how many people compare eastern European prices with UK prices and remark how cheap property is there. There seems to be an underlying assumption that the low prices are simply lagging behind those in the UK and that they will one day catch up. This view tends to ignore the fact that there is no shortage of property in many countries, plus the rush for rapid economic development also means that these countries are unlikely to put the same obstacles in the way of new property developments as the UK or France might.

The whole experience of owning a property abroad is different from the bottleneck system that is the UK housing industry. Supply of new build property has increased dramatically in most holiday hotspots and many people who have bought apartments in new developments find it very difficult to sell when there are 200 new apartments being built just down the road. New apartments tend to attract a premium price initially but after a year or two they are no longer new and can’t compete. In a rising market this isn’t such a problem but in a market where prices are falling it can be disastrous for highly leveraged buyers. If more people are forced to sell their second properties because of rising mortgage rates, worries about exchange rates or simply more urgent demands on their income at home, there is likely to be a flood of properties into the market at around the same time.

In addition, due to the long lead time between giving the green light for a property development and the final completion of the project, there is unlikely to be a slowdown in new supply for some time. This has been well illustrated in the US where there is 9 months of new housing supply waiting to be sold.

Whereas owning a second home has been easy in recent years due to cheap and available finance, things have now changed and we are likely to see a reversal of the trend to own. This is due to several factors:

- Mortgage rates are rising and people are paying more each month for their property.

- Other everyday expenses such as fuel bills and buying food has increased dramatically in price, which means there is less disposable income available for luxuries.

- Paying for two lots of council tax, two lots of maintenance expenses and two lots of mortgage refinancing fees is all going to be a drain on resources if budgets are tightening.

- Cheap flight prices have increased in recent years as fuel prices have soared.

- Many loans in eastern European countries are taken out in low-yielding foreign currencies such as the Yen and Swiss Franc. These currencies have strengthened considerably recently which increases the size of the outstanding debt.

Whilst the pressures of owning a second home have increased there is further bad news for those wishing to sell:

- Supply of new developments has not yet peaked in most countries (with the possible exception of the US) and supply is probably outstripping demand now.

- Mortgage applications in the UK are now running nearly 40% lower than a year ago which means that the number of potential buyers has dropped off a cliff.

- The media has latched onto the negative sentiment in the property market in many countries and this is a blow to confidence. Inexperienced investors who would previously have jumped on the bandwagon will now hesitate.

- Many people who initially found it relatively easy to buy property abroad are finding out how difficult it is to sell when everything isn’t laid on for you. In many countries the local population can’t afford the prices asked for new developments and that only leaves the overseas market in which to sell.

Owning a second home has gone from being a luxury only the rich could afford, to being quite commonplace, and is soon likely to be viewed as a step too far for many families. If the UK experiences a serious economic downturn as many people are predicting, that is going to mean higher unemployment, less job security and less chance of getting a pay rise. Most people could soon find themselves financially much worse off and many of those people who own a second home are going to feel like they have a huge millstone around their neck.

The explosion in easy credit in recent years has created a strange state of affairs that has allowed people to feel as though they are wealthier because their purchasing power has increased, as they have been able to borrow more and more money. The equity in their property has made them feel wealthier, even though they have to borrow against it in order to spend it. The availability of cheap credit, alongside a society that is obsessed with celebrity worship and all the material trappings that goes with a successful celebrity lifestyle, has enabled many people to escape the chains of their static incomes and their dull lives and they have been able to buy into a whole new lifestyle if they want to.

The boom in second homes has been a symbol of British society’s detachment from reality and this illusion is very likely to end in tears, and very soon. Whilst the UK’s love for holiday investment properties is not likely to become our very own sub-prime disaster, there is no doubt that a large number of people are going to find that an expensive illiquid investment can be something of a nightmare in a falling market and I expect to see a lot of bad luck stories emanating from this sector for many years to come. Bargain hunters should keep their powder dry for now but watch out for some fantastic deals in the next few years.

Sell, sell, sell!!! Oh no, you can't.....

2008-02-08T07:15:00.000-08:00

After several years of very enticing double-digit returns and massive inflows of private investor money, the UK commercial property sector is now seeing huge numbers of investors attempt to take their money out. I say ‘attempt’ because many popular funds have imposed long notice periods for withdrawals in order to stem the flow and many people are finding that commercial property unit trusts are not the liquid investment they were claimed to be or were sold as.

One of the main selling points of unit trusts is their liquidity. Property is traditionally a highly illiquid asset class. It takes time to buy and sell a physical property, much longer than it takes to buy or sell a share for example. Therefore, property unit trust managers are usually obliged to keep a certain amount of available cash in their fund to satisfy redemptions when they were requested. However, funds don’t want to hold too much cash because this can dilute overall returns. The problem in the last few months has been the sheer volume of investors wanting to redeem at the same time as there hasn’t been enough cash in most funds.

New Star Asset Management had one of the most successful retail property funds, advertised on billboards across the country last year and valued at £2.2bn. However, after large markdowns in its net asset value, it recently announced that around £500m has been withdrawn from its flagship fund. That is quite a chunk of money to find in a short period of time. Many funds have been forced to sell properties into a weak market to raise cash. When a sale is forced, and valuations are falling, the extra property coming into the market just pushes down prices across the board. Now the big employers in the City of London are starting to reduce headcount and the demand for office space is dwindling.

There are still plenty of new construction projects under way, due to the long interval between getting the green light for the project and the final completion, which means that the supply of offices and shops is increasing at a time when demand is falling. The explosion in new ‘landmark’ construction projects such as the Shard in London will seem like a familiar sign to anyone who watched the Canary Wharf saga unfold at the end of the last property boom and to more seasoned investors it is surprising that we have seen the property boom continue for so long. There has been a huge amount of new construction in recent years as small, old buildings have been torn down to make way for higher and more modern properties. And when you regularly see fully functioning businesses bought and closed down so that their buildings can be turned into apartments or offices, you realise that the business of property, itself often a necessity of business, has become the tail that is wagging the dog.

Property cycles come and go but this one was the mother of all property cycles, both in the UK and in many other countries. It is normal for cycles to end, to recede and then rise again, often even stronger than in the previous cycle, but this time the rush into property was almost frenzied and the exodus out of it was even more rapid. More than £20bn has been invested by small investors in the sector since 2002. Property has long been considered a relatively stable asset class, certainly more so than the stock market, but there has been nothing stable about the collapse in commercial property prices and in the share prices of the companies that invest in commercial property. Many funds have seen valuations fall by more than 15% in just a few months and listed property companies have seen their share prices fall 40% or more.

However, even though this cycle may have ended more severely than past cycles, it is the behaviour of the unit trust managers running the commercial property funds that have presented the industry with their next challenge: how to convince investors to put money into funds that they might not be able to access in falling markets? Many investors have made paper gains in recent years in commercial property funds but a lot of them probably won’t get the opportunity to realise those gains because they can’t withdraw their money for up to 12months. Imagine if all investors across all markets, upon discovering that asset values were falling, were told that they were not able to remove their money. The financial system would collapse.

The very name ‘unit trust’ implies that investors entrust their hard earned savings with the fund managers and expect them to invest it accordingly. But now any semblance of trust between investment managers and investors has been destroyed because it is only when the unit trust statement comes through the door and the investor tries to remove their funds that they realise who has control over their money. If banks suddenly imposed a 12month notice period on formerly-accessible bank accounts then there would be widespread rioting in the high street but investment companies seem able to get away with it.

Maybe in a few months time, when more small investors have received their fund statements and after commercial property values have fallen even further, will we see more protests in the media. It’s possible that we will see investors queuing outside the offices of Jupiter Asset Management or Fidelity Funds, angrily demanding their money to be returned. Or will it become the norm for investment companies to be able to increase the notice periods on funds as they deem appropriate? Will we see the same thing happen to other asset classes? Even though stocks are more liquid, it could be argued that a significant increase in withdrawal demands would increase the level of selling in the stock market, pushing prices down further. In this scenario, should the investment management industry be able to attempt to prop up the market by refusing to sell stocks and refusing to give clients their money back until markets are more calm?

Maybe these extended lock-in periods are simply a sign of the times we are living in today. It appears that many of the largest banks and hedge funds have not been pricing assets to market as they prefer to wait until markets return to ‘normal’. To someone working outside the complicated world of hedge funds it sounds more like they don’t want to be forced to price assets at these levels and are waiting for better prices before they go public with their losses. This kind of attitude might explain why so many of the losses that have been announced have been huge and rather out of the blue. Investors lost a lot of faith in corporate executives after the Enron debacle but it looks like some people at the top of large corporations saw it as a good example of how to cover up problems. It seems that investments are becoming less transparent and some investment managers and chief executives are becoming a law unto themselves.

If unit trust managers start imposing longer notice periods on normal investment funds then investors would have to reconsider whether those funds are as safe as previously thought if there is a question mark over how long it will take to get our money back.

In the longer run, maybe a couple of years from now, we could find that investors distrust of investment management companies has grown significantly. If commercial property values keep falling then there is going to be greater demand for withdrawals and a greater need for fund managers to stop those withdrawals. This could easily be another financial markets scandal that the FSA will have to deal with by drawing up new legislation to regulate the industry and it could be a serious blow to confidence in the industry in general. If the economic slowdown develops into a major global recession on the scale of the 1930s depression, which is a longshot but a possibility, then there is going to be huge scramble to sell assets and the most illiquid ones are going to cause the biggest panics. I suspect we’ll hear more about this issue in the not-too-distant future.

Strong Dollar policy: Is the Fed wearing the emperors new clothes?

2008-02-08T01:33:00.000-08:00

The Dollar is still widely seen as the world’s reserve currency, namely the most secure, most liquid currency in the world today. However, anyone living in a country who’s currency isn’t pegged to the Dollar, ie most countries, will have lost a lot of money over the last few years if they have been holding the Greenback. Since the start of 2002 the US Dollar has lost 43% against the Pound, 40% against the Euro, 31% against the Swiss Franc and 37% against the Canadian Dollar. It’s even depreciated against the Yen. For many investors, holding the reserve currency must seem like a license to lose money.

After slashing interest rates to 1% after the dotcom crash, another classic example of financial market mismanagement, the Fed has since raised rates until this year when it started cutting again. Even during this period of monetary tightening, the Dollar struggled to retain its value. The US Federal Reserve has maintained that it has a ‘strong Dollar policy’, which in terms of credibility ranks alongside those other famous US beliefs such as the existence of weapons of mass destruction in Iraq (remember those?) and that Elvis is alive. At the very least someone should inform the Fed that their policy doesn’t seem to be working….. and that it would be difficult for someone as famous as Elvis to hide away for this long without being discovered.

In reality there are plenty of arguments to explain why the Dollar is so weak and why it is no longer needed as the worlds reserve currency. Firstly, the US is the world’s largest debtor country, having formerly been the world’s largest creditor only a few years ago. It can be described as ‘living beyond its means’ and if it were a company it would probably be declared insolvent. In fact, the plummeting value of the Dollar means that the US is, in practise, holding a liquidation sale of its assets such as US treasuries, property and well known businesses, all of which can be bought at knockdown prices by the overseas investor.

Secondly, the Euro provides a handy alternative and is certainly liquid, tradable and relatively strong. Iran already sells its oil in the Euro denomination and other countries are at least considering making the switch. At the last OPEC meeting one of the microphones was left on after the press conference had finished and several ministers were unwittingly heard discussing the subject. Oil producers have been protected from the weak Dollar by rapidly rising oil prices but they probably can’t help thinking how much richer they would be if the US and other countries were forced to pay for its oil in Euros.

Thirdly, if the Federal Reserve continues to print more Dollars each time the economy sags then the Dollar is simply going to be devalued even further. It goes against the laws of nature that something so abundant and easy to create, by simply printing more, should be used as a store of value. In the world of commodities it is the least abundant metals and energy products that are the most highly valued. Gold is doing a great job in its role as the anti-Dollar, with the price having nearly tripled in the last 5 years, because it is a store of value and because supply is limited. If we could master the art of alchemy and simply make gold whenever we wanted then a large part of its value would be lost. This is what has happened to the Dollar. I’m sure that the Federal Reserve Chairman was only trying to be colourful when he said they would drop Dollar bills from helicopters if the economy needed reflating but that comment is on a par with Gerald Ratner saying that his jewellery company’s products were cheap because they were crap, a remark that caused sales to dry up and the company to go bust.

With the US possibly heading for a recession, after years of excess leverage that is now unwinding, the attraction of US assets is waning even further. The question now is “why would you want to invest in US Dollars at all?” There is no good reason; there are alternative currencies that are liquid, there are plenty of attractive foreign assets if you are in the mood for buying up a company and the US is no longer particularly welcoming to foreign ownership anyway, especially if you come from the Middle East.

The US is still considered the premier location for entrepreneurial activity and is the spiritual home of capitalism, materialism and the equity culture but in recent years it has become more of a leader in off balance sheet financial engineering, collateralised debt obligations and sub-prime lending. The spirit that once drove the American Dream is looking a little tarnished and is facing some strong competition from other quarters such as Vietnam (rather ironically), China and India. If the fundamental reasons for investing in the States are becoming less clear then the demand for more Dollars is going to get a little thin. Even the Chinese have realised that it might have been prudent to spread their foreign currency reserves around a bit, having lost billions of Dollars whilst they watched the local currency value of their assets fall. Still, they are probably happy in the knowledge that they could dump their foreign reserves tomorrow and bring the US economy to its knees if they wanted. They probably won’t do that, but they could, and it puts the Americans in a position of weakness.

So, at what point will the Federal Reserve admit it has a problem, and seek help? As Alcoholics Anonymous say, admitting you have a problem is the first step. But many alcoholics can’t give up because they like drinking. And the Fed likes the fact that US exports are a lot cheaper if the currency is weaker, and therefore people start to buy more from them. But ultimately a weak currency is inflationary, as prices of imports rise and interest rates need to rise to attract capital inflows. America can’t afford to raise rates now, at the end of history’s largest credit boom, so it remains to be seen what solution they come up with. But if the Arab states or any other countries that are pegged to the Dollar decide to break those pegs, they will have to do something, or the Dollar will spiral out of control. At that point, make sure you are holding gold.