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.
Tuesday, March 25, 2008
Thursday, March 20, 2008
Return of the bear market.
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.
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.
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