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Crisis or opportunity?

18 March 2008 Investec Asset Management

Max King, Strategist at Investec Asset Management, gives his personal view on global market events

Anyone who has been following the news or the movements of markets could be forgiven for assuming that the world’s financial system is locked in a death spiral of collapsing confidence, cascading insolvency and falling asset prices. We have all learnt, many times, that every moment of crisis is always also one of opportunity, but such a lesson is always learnt easiest with the benefit of hindsight, rather than at the time.

According to past crises, what would we expect at the bottom of the current one? Firstly, one or more major financial collapses or near misses, comparable to the Savings & Loans Associations in 1989, Continental Illinois in 1994, Long Term Capital Management and sovereign emerging market debt in 1998, Enron and, nearly, Citicorp in 2002. We would expect universal fear of a domino effect of further collapses, participants in all markets to be frozen into inaction as liquidity dried up, equity markets to develop a remorseless downward momentum and all hopes of a turnaround to be indefinitely postponed.

In other words, exactly what we have at present. Northern Rock was always too parochial a UK crisis to mark the defining insolvency of this cycle. Bear Stearns fits the role far better. It is possible that there will be others, but don’t count on it. In late 1974, rumours swirled that National Westminster Bank was insolvent, leading to a formal denial (which only undermined confidence further). In 2002, Prince Walid of Saudi Arabia restored confidence in Citigroup by buying every available share until the price started recovering.

The news appears to be getting worse, but is it really? The US economy is probably in recession, as was expected. US houses prices are still falling, again as expected, but are at or close to a low point. Estimates for the provisions required for defaults on sub-prime mortgages, similarly low-quality junk bonds and related derivatives are no longer rising: further specific write-offs are inevitable, but transfers from general to specific provisions for bad debts do not increase the total estimate of losses.

The recent insolvencies at Peloton Partners, Carlyle Capital and Bear Stearns are not even associated with bad debts but with a lack of liquidity in prime quality, government backed bonds which have no chance of defaulting unless the US government defaults. As liquidity dried up, investors required an increasing yield premium to hold them, so prices fell. This led to margin calls on highly leveraged portfolios, forced sales, further drops in prices and an increasing liquidity premium. It may look as though the bonds are discounting a risk of default, but anyone who buys them with real money and holds them is certain to be repaid at par.

Just because the derivatives of these bonds are called Credit Default Swaps does not mean that they measure a risk of default: they also measure a premium for illiquidity. This is important because it means that markets are not facing a risk of insolvency by US government agencies (such as Fannie Mae or Freddie Mac) or AAA corporations. The more liquidity contracts and prices fall, the more it will return and prices recover. Either the US government steps in to remind investors that it is not going to renege, or it injects more liquidity into the market, or it physically buys in the bonds, financed by issuing Treasury bonds, or US corporations start buying in their debt at a discount. More probable is a combination of these measures combined with greed overcoming fear in investors’ minds as those with cash in the bank, borrowing facilities or holdings in Treasuries switch into low risk credit for the higher return.

Credit markets are the dominant short term influence on equities in the short term, but valuation, earnings growth, the support from government bond markets and sentiment are decisive in the medium term. Valuation is excellent, and the low yield on government bonds makes equities excellent value in relative terms. Sentiment is at rock bottom, and can only improve – it is just a matter of when. The fall in corporate earnings forecasts has been the factor holding us back from short-term bullishness, and that fall is continuing.

However, there is a glimmer of light at the end of the tunnel. The margin by which the number of analysts’ downgrades exceeds that of upgrades has declined in the last month, while the scale of overall net downgrades has not increased. Earnings forecasts for 2008 have been cut by 1.4% in the last month, a little less than the 1.7% in the previous month, but they still show overall growth of 11% this year. It is probable that a small number of large downgrades is pulling the overall figures down. There is a tendency for strength to lag breadth in earnings forecasts – if the margin by which the number of downgrades exceeds upgrades continues to fall or turns negative, then forecasts for earnings growth this year will subsequently start to rise.

11% growth may still be too optimistic, but a range of 5% - 8% is not, and the market expectation of a sizeable fall looks far too pessimistic. Also, as the months roll by, the further growth likely in 2009 becomes more tangible. This means that, before long, value, which is already cheap, will be improving rather than fading as the weeks pass. Three of the four market drivers are now strongly positive, and the fourth is becoming less negative.

The best definition of a contrarian opportunity is when market momentum has failed to take notice of a change in direction of the fundamentals. An increasing gap then opens up between what the market discounts and what is actually happening. We are at that point now: markets may not be at the absolute low, but it would require luck as well as judgement to pick that. With the Federal Reserve about to slash interest rates again and other Central Banks sure to follow, it is a time to embrace risk, not to avoid it. Markets will recover as quickly as they have fallen, and it will be much harder to buy on the way up than now.

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