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.
Wednesday, June 25, 2008
Thursday, June 12, 2008
The Domino Effect
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.
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.
Wednesday, May 14, 2008
Inflation, deflation, stagflation.
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.
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.
Tuesday, April 15, 2008
The Sad Tale of the Fall of the Magic Kingdom.
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.
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, 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.
Subscribe to:
Posts (Atom)
