Stanlib Market Update

UPDATE ON THE CRISIS AFOOT IN WORLD MARKETS

· Alan Greenspan has been quoted as saying that the US (and therefore the world) is experiencing a once-in-a-century financial crisis.

· Lehman Bros was 158 years old and survived the Great Depression of the 1930’s, yet has fallen on its sword during this crisis, partly because it was a major underwriter of mortgage-backed securities and was hard hit by the sub-prime crisis.

· Its demise may cause problems in financial markets for some months to come.

· What has gone wrong in financial markets? A long period of rapid economic growth, low inflation, low interest rates and general economic stability bred complacency and increased the willingness of both individuals (property) and financial companies to take risk. Rising interest rates in the US burst the residential property bubble two years ago and since then the problems have largely come from this area. An end to the fall in US house prices remains a key to ending the crisis. This has not yet occurred. The sub-prime crisis may not end until the US housing market reaches a more affordable level.

· AIG, one of the biggest insurance companies in the world, is a prime example of the heightened risk-taking. It has many excellent businesses, but in the late 1980’s it formed a new financial business which subsequently wrote billions of dollars of derivatives, which are now at the heart of its woes and are far removed from its core insurance business (FT, 17^th Sept). In particular, it began insuring investors against defaults on collateralized debt obligations (CDOs), or pools of securities. This and other similar securities accounted for the bulk of the $41bn dollars written off recently and has led to the US Fed buying almost 80% of its shares and extending a loan facility of $85bn to the company, thereby throwing it a strong life-line.

· It is gratifying to see that not all of these American investment banks have been poorly managed. Although Goldman Sachs’ third quarter profit fell 70% from last year, it still made a net profit of $845 million in possibly one of the worst quarters in modern history. How? The company is seen to be a class act in risk control, ie its top leadership is excellent.

· BOTTOM LINE: The crisis is not over as long as property prices continue to fall. This means that uncertainty/risks remain high. How many other financial companies will fail? This is impossible to predict, but the probability is fairly high of further failures.

· Developed market economies are slowing and recessions in the US, UK, Europe and Japan are distinct possibilities. This puts pressure on company earnings.

· Global stock markets are in strong down-trends (bear markets). As yet, there is no evidence that these are ending, although sentiment is extremely negative and in most instances shares look good value, for example in Asia (excluding Japan).

· The JSE All Share Index is down 25% from its high and is currently close to the lows seen in January this year.

· Part of the JSE’s fall is related to the sudden sharp fall in commodity prices (platinum is down 50%), which in turn is related to both the stronger dollar and fears about Lehman Bros and AIG. Investors in the DJ-AIG commodity index have sold $10 billion of commodities since Monday (more than 5% of all funds tracking commodity indices). Lehman had $5 billion in the commodity index business.

· The FT quotes John Reade, a commodity strategist at UBS, who says investors in commodity indices were increasingly aware that they did not own hard assets, but rather a swap on an index of commodity futures…with counterparty risk. Therein lies the rub and the panic with regard to Lehman and AIG.

· Now that AIG is saved, this panic selling of commodities may end and possibly turn the other way. Most of the resource shares are down 40%.

· Although the JSE’s Financial & Industrial index has fallen over the past few days, it remains 9% above its lows in July.

· The JSE looks good value all-round, but if world markets continue to fall, the JSE may do likewise.

· The good news is that bond yields have fallen offshore and in SA, meaning bond values have risen, plus the oil price is down 38%, the dollar maize price is down 30% and the dollar wheat price is down 46%, the latter two because of excellent US crops. These are very good signs for lower inflation and therefore lower interest rates globally and in SA.

· With the MSCI World Index down 27% (in dollars) at 2005 levels and the JSE All Share Index down 25%, we don’t think this is a time to be selling, even though there may well be more downside to come.

· Rather, partly because of the uncertainties which are reflected in low prices, we think it makes sense to be gradually accumulating (perhaps on a monthly basis) both offshore and local equities.

· Stick to your investment plan within your risk profile. Remember that over the past few months in SA, three of the four asset classes have done well (listed property, bonds and cash).

· STANLIB’s local portfolios (SA funds) had no exposure to either Lehman Bros or to AIG. Of the offshore portfolios, the only exposure was a small exposure to Lehman Bros bonds.

· SA financial institutions appear to be largely free from the problems experienced by the big developed market banks. It is highly unlikely that any major SA bank will incur any material charges related to the US credit crisis.

· Note that most stock markets around the world have experienced severe declines, including India (40%), Russia (50%), China (70%), Brazil (35%), Hong Kong (44%) and the top 50 shares in Europe (32%). Our market has outperformed the MSCI Emerging Markets Index by 15% so far in 2008.

· In the pdf file (click here) we show graphs of the JSE All Share Index, the MSCI Emerging Markets Index and the MSCI World Index (of mostly developed markets).

Click here to download the full report (PDF file 490kb)