A cool head will prevail in turbulent times
The events of the past few months have been of truly staggering proportions. It would be hard to give a full account of them without resorting to excessive hyperbole, or lengthening this article even further. Allow me instead to begin with an analogy: The end of the quarter saw the death of screen legend Paul Newman. This prompted me to re-watch his old classic “The Sting” which also starred a still-very-boyish Robert Redford. The story is one of grand deception at the end of which the “mark” is painfully parted from his money, and the apparatus of the scam is dismantled with remarkable speed and efficiency.
And so it has been with financial markets. After a multi-year build-up of easy-credit-based excesses, the deceptive nature of the game has been revealed. With startling swiftness, the players have been brought to book and their businesses removed from the financial playing field. In what follows, I’ll first give a brief summary of market performance. I’ll then offer a few insights into the dramatic events that have been happening around us. And I’ll conclude with some implications for portfolio positioning and the way forward.
Performance summary
The 12 months to end-September have seen returns of –18.0% from the All Share Index, +8.5% from the 1-3 year Bond Index, +11.3% from the money market and –10.7% in rands from the MSCI global developed-markets equities index. Consumer price inflation over the period ran at +13.6%, continuing to make inflation-plus targets hard to beat for now. Of course these numbers don’t tell the whole story. Some very steep declines in global financial markets have happened over the last quarter, and since quarter-end.
In the context of dramatic world-wide equity market declines, I’m pleased to report that we have consistently maintained our less-than-gutsy equity exposures in the 3 inflation-targeting unit trusts (the PPS Conservative, Moderate and Managed Flexible Funds of Funds). I am very pleased with the strong performances of the PPS Enhanced Cash and Flexible Income Funds. The PPS Equity Fund has beaten its benchmark over the quarter but, in retrospect, would have benefited from a greater exposure to the less-benchmark-aware managers in the mix.
What on earth is going on?
In his recent book “Hedge Hogging”, veteran investor Barton Biggs quotes the adage that trying to find out what’s going on in the world by reading the daily paper is like trying to tell the time using only the second hand of your watch. This has been particularly true of late.
The headlines have been captured by the drama of the US government’s bail-out of loan guarantors Freddie Mac and Fannie Mae and of giant insurer AIG. On the other hand, we have read of the same government’s allowing a 157-year old investment bank Lehman Brothers to fail, and of the Bank of America’s purchase of ailing Merrill Lynch. Earlier in the drama two Bear Sterns hedge funds collapsed after sub-prime loan investments turned sour, to be followed 8 months later by the collapse of Bear Sterns itself and its subsequent sale to JP Morgan for $10.00. Towards the end of the quarter investment banks Goldman Sachs and Morgan Stanley completely changed their stripes and were swiftly converted to conventional bank holding companies.
The investment banking misery spread to other parts of the US financial system and to other parts of the globe. Initial concerns about Washington Mutual, the US’s 3rd largest bank, proved well-founded and its collapse and sale to JP Morgan constitutes the biggest banking failure in US history. Wachovia, the 6th largest US lender, folded shortly thereafter, and was taken over by Wells Fargo after an initial standoff with Citigroup. While all this and more was going on in the US, on the other side of the Atlantic UK mortgage lender Bradford & Bingley collapsed and was nationalised, as was Northern Rock before it, as were Glitnir Bank and 3 others in Iceland. Also in the UK, HBOS bank found itself in severe funding difficulties, and was acquired by Lloyds TSB.
Many central banks, national treasuries and legislative bodies have responded to the crisis. I’ve already mentioned a few of the bail-outs and guarantees above. The European Central Bank came to the rescue of Dexia Bank as did Belgium and the Netherlands for Fortis Bank, the Reserve Bank of India for ICICI Bank, the largest in India, and Ireland for all six of its largest lenders. The $700bn US Troubled Asset Relief Program (TARP) was initially rejected by the legislature, prompting further market carnage, and something of a rally on its passing by the Senate on 2 October. A week after quarter-end several of the world’s central banks, including China’s, launched an unprecedented co-ordinated interest rate reduction, but equity market declines continued unabated, demand for allegedly risk-free US Treasury assets remained intense, and inter-bank lending rates remained stubbornly high.
So what’s really going on here? I’m reminded of the following from economist Lord Maynard Keynes
“In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean will be flat.”
This tempestuous season had its origins long before the first bankruptcies of sub-prime mortgage lenders American Home Mortgage and New Century Financial Corporation in the second half of 2007. And it is more complex than simply the failure of banks which made questionable loans to insubstantial borrowers. Yes, the souring of the sub-prime mortgage bubble has been an important catalyst, but I believe that we are seeing the unwinding of systemic asset bubbles fuelled by decades of relatively low global interest rates, lax credit granting standards, global financial market integration, and de-regulation or self-regulation of financial market institutions.
I mentioned above that inter-bank lending rates have remained stubbornly high, despite central bank rate cuts. This is a crucial observation. It is the result of the world’s commercial banks, spooked by the sub-prime-related defaults of their peers, being unwilling or unable to lend to each other. Many banks currently believe they can not trust each other to repay even overnight loans. This has left them in a severe liquidity (if not solvency) crisis, and required the intervention of central banks and national treasuries to provide liquidity and recapitalise them. The fact that inter-bank lending rates remain at record highs indicates that the confidence of banks themselves in the global banking system has yet to be restored. Think of it as a very modern, and wide-spread, equivalent of a retail banking run, draining liquidity from the entire banking system.
Catalysts like the current sub-prime crisis often strike when the tide of economic fortunes has already turned down. This was true of the great Wall Street Crash of 1929, and was true most recently of the 9/11 terrorist attacks in 2001, and of many crises in between. A recession in the US, led by reduced US consumer spending, and a global economic slow-down, are now firmly on the radar screen. This implies, inter alia, reduced immediate demand for South African commodities exports, and helps explain the –38.3% fall in our investable resources index over the quarter. I thus believe it would be myopic to expect an immediate, smooth or sustained recovery in economies or markets. Two silver linings are worth noting: the reduced fears of inflation allow the world’s central banks more scope for interest rate cuts, and the internal economies of China and India still appear robust for the foreseeable future.
Positioning for the future
These are dramatic times indeed. Extreme uncertainty abounds. But then, financial markets are always uncertain to a greater or lesser extent. What’s important is consistent adherence to the simple verities of investing. By far the most important of these is: buy assets when they’re cheap (while avoiding what’s deservedly cheap). At PPS Investments our adherence to this principle goes a long way to explaining our very conservative stance to date, and our likely positioning going forward. Since implementing our first investments, we have been consistently cautious about the valuation levels of certain asset classes and market sectors, particularly local listed property, long-dated bonds, and resources stocks. We have accordingly biased the funds entrusted to us away from these expensive assets.
Of course we don’t possess the fabled crystal ball, but I have seen several times over my investing career that while market events are not forecastable, valuation episodes are usually plain for all to see. So … how will we be positioned now? We’re aware that equities are looking cheaper than they have for quite a long time. However, we are still cautious as we know that South African companies are coming off a multi-decade peak in corporate profitability, some of which is still reflected in current price levels.
In other words, South African shares may be cheap by the standards of recent history, but they are not nearly as enticing in the context of a global economic slow-down, and anticipated reduced corporate profit margins. And although the most acute phase of the global shake-out may now have passed, after-shocks are bound to still occur for some time to come. Our approach may therefore be to very cautiously increase equity weightings towards our strategic long-run target allocations. But we will not do this by simply allocating capital to equities managers. Instead, we are more likely to achieve this by up-weighting our clients’ exposures to genuinely-skilled balanced managers like Prescient Investment Managers (PIM) who ably use financial instruments to protect our clients from inevitable equity market declines.
Not only will our exposure to local equities remain cautious, but our exposure to global equities will probably not be fully weighted, and will remain firmly indexed. Indexing global equity exposure over the past several months has already allowed us to very handsomely out-perform actively managed alternatives, whether before or after management fees. Outside of equities, we remain cautious of listed property and long-dated bonds, and are pleased to see that our appointed fixed-interest managers are not over-anxious to avail themselves of the now more-enticing yield spreads available on South African corporate debt issues.
In summary then, we are very mindful that: “Other peoples’ money is … other peoples’ money.” We will continue to be cautious with the valuable funds that have been entrusted to us. Where we increase exposure to more favourably priced asset classes, it will be:
1. to help achieve our clients’ strategic multi-year objectives;
2. protected where possible against short-term surprises;
3. implemented by managers we regard as genuinely skilled;
4. in as cautious and cost-effective a manner as is possible;
5. supported by analysis and research of the highest order.
