It’s safe to say that no-one predicted the magnitude of the global credit crunch’s impact on markets. In less than a year, some of the more venerable banking names, such as UBS, Merrill Lynch, and Citigroup, have reported enormous losses; Bear Stearns has disappeared completely. This crisis has spilled over into the broader economy, to a degree that economists are now arguing about whether or not the US is in recession. Across the Atlantic, the giant British mortgage lender, Northern Rock, has been effectively taken over by the Government. Before the US sub-prime crisis, there was no hint that it was in trouble; its loan book was healthy and it was well capitalised.
Australia has not been immune, with RAMS effectively ceasing to exist for similar reasons as Northern Rock. It’s not just the sub-prime crisis, of course. Up to a year ago, the economic outlook looked positive.There were concerns in the US about rising inflation, as well as the budget deficit. But the emerging powerhouses of China and India, enjoying their nascent industrial revolutions, were steaming ahead, underpinning commodity booms. Today, it’s a far different story, and not just because the credit crunch will force financial institutions, central banks and governments to fundamentally rethink how the global financial system works. The US sharemarket is off about 22 per cent from its peak in November 2007; in Australia, the ASX 200 index is off 27 per cent from its peak last year.
At the same time, oil prices have skyrocketed – more the product of growing demand than dwindling supply. This treble whammy is undermining consumer confidence overseas and locally to a degree not seen since the recession of the early 1990s. In this economic and political environment, a shakeout of the system is inevitable. But before detailing where that is occurring, and how it will impact on asset allocation, it’s important to stress that downturns, while never enjoyable, are part of economic life. Indeed, you know when a bubble is about to burst when analysts, who should know better, start saying, “this boom is different”.
So what change will the current economic and financial turmoil usher in? In my opinion, there will be two critical changes for Australia, and both should influence asset allocations. First, there seems little doubt that once the dust has settled over the sub-prime crisis we will have a different set of priorities in the global banking and financial systems. These changes will be self-imposed, as well as the product of government and/or central bank intervention. Many in the financial world are now paying (belatedly) more attention to risk management, acutely cognisant of the fact that their old systems failed to successfully manage the risks generated by the current crisis; they were still on the merry-go round when the music stopped.
All existing risk management practices and internal business mixes will come under the microscope. We can expect more stringent capital requirements, increased regulation and forms of credit rationing to avoid similar problems occurring again. Governments, and their regulatory authorities, will legislate accordingly, much in the same way the US legislated in the wake of Enron’s collapse. But the market is way ahead of the legislators. Ask any business that has tried to raise funds in recent times and they’ll tell you about the extra hurdles that have been put in place before they can get their hands on a credit facility.
Banks, building societies, mortgage originators, indeed, all credit providers for that matter, are instilling more discipline into their lending practices, and, rationing credit at the same time, trying to strengthen their balance sheets. But this latter-day financial prudence is coming at a cost to business and the markets. Investors are finding it hard to get funding, and the consequence is to reduce liquidity and demand for stocks, bonds, property and assets in general that had come to rely on geared investors. Profitable companies are also finding it hard to get funding, and if they do, it is at a significantly higher cost than recent years.
The consequence is a deleterious effect on the broader economy. And for banks it means it will be that much harder to strengthen their balance sheets. The above does not bode well for stock prices in the financial sector. Until it is clear what the new business mix for revenue growth is, the sector will remain under pressure. Adding to the sector’s woes is the need to raise capital that is creating its own version of a liquidity trap. As the stock market falls it becomes harder for companies to raise capital; an ongoing and significant rerating of their stock prices being the inevitable consequence.
Australia was never going to be immune to the sub-prime virus; the US economy still generates 25 per cent of global GDP, so any downturn was never going to be contained inside America’s borders. Perhaps the more pertinent question to ask is to what degree Australia has decoupled itself from the US economy compared with decades past. In my opinion, this could prove the other hugely significant change for our economy. Why? As the G8 conference demonstrated, China and India (and, it can be assumed, other emerging economies) are not going to be dissuaded from a growth strategy. These economies are throwing us a lifeline in the form of higher commodity prices (oil and food), but this demand, while providing shelter from the US downturn, is bringing in its wake higher inflation.
Higher inflation numbers change the rules of the asset allocation game. Expect companies, especially the industrials, to begin announcing earning downgrades, and for price/earnings ratios to be re-rated. Compounding the problem is an underperforming property market, with its knock-on effect to the all-important construction industry, as well as consumer confidence. So, in considering these macro effects, what shifts should be made within an asset allocation? Investors should identify high-conviction managers and alternative strategies, such as longshort equities.
The traditional practice of holding the market may now simply mean increasing your exposure to the adverse macro factors that have taken a toll on equity markets worldwide. In the same vein, investors should be wary of moving into the property markets, a well-trodden path in the past as a hedge against inflation. Quite simply, the ongoing uncertainty in credit markets, and the increasing likelihood that there will be no easing in the availability of credit for the foreseeable future, leaves a considerable question mark hanging over these asset classes. Assets that are decoupled as far as possible from equity markets and that are expected to outperform cash returns warrant a higher allocation. Commodities fall into this basket, with gold the most obvious example.
Alternative strategies, too, should play an increasingly bigger role in a portfolio, such as fund-of-funds hedge funds and long-short strategies for credit, foreign exchange or equities. Finally, there seems little argument that some steam is going out of the Australian economy; the Reserve Bank’s strategy of lifting official rates to slow down the pace of growth is working. In this environment, the share prices of stocks with a domestic focus will come under pressure.
Conversely, shares with an export focus, particularly in Asia or emerging markets, would appear better situated to ride out any downturn. And don’t just think commodities; there are any number of companies that are either exporting to Asia or setting up profitable operations in the economies to our north. It is interesting to note that Australia’s economy hardly missed a beat during the Asian economic crisis during the late 1990s, because it hadn’t yet become solely dependent on Asian markets for its economic prosperity. Now, we must look to Asia and the emerging markets in general and the demand they generate to stand between us and the weak US economy. We used to say when America sneezed, we caught a cold. For our economy’s sake, let’s hope that the emerging markets remain healthy.