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.
Tuesday, April 15, 2008
Tuesday, March 25, 2008
The Liquidity Bubble.
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.
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.
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.
Monday, February 18, 2008
How did so many people come to own two houses?
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.
Friday, February 8, 2008
Sell, sell, sell!!! Oh no, you can't.....
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.
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?
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.
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