Another attempt at deciphering the financial system meltdown

Gareth Stokes, FAnews Online Editor

How do you measure an economic collapse? Ant Lester, managing director of Fifth Quadrant, used the performance of the MSCI World Index (a basket of shares representing the global economy) relative to cash. In a presentation at the Actuarial Society of SA

Thankfully investors have short memories. Two months ago it seemed financial system instability was here to stay and shell-shocked punters would remain in cash and other ‘safe’ asset classes forever. What a difference a few positive trading days make. South African equities have posted solid gains as international investors’ risk appetite returns. As money moves from low-yield treasuries, corporate bonds and other cash instruments the JSE All Share jumped a massive 53% in US dollar terms between 9 March and 20 May 2009! It’s even possible, many years from now, that market analysts will identify March 2009 as the ‘bottom’ for the equity market collapse that grew out of ‘sub prime’.

Has the world learnt its lesson?

Before we’re swept away by talk of an imminent trend reversal it would be prudent to reflect on the behaviour that triggered the crisis. Analysts are still sifting through the financial debris for answers. Lester reckons the simplest explanation for the crisis hinges on “excessive borrowing at really low interest rates.” And a growing number of experts point to the dotcom bust at the turn of the millennium as the root cause of the current financial contagion. They suggest US authorities glossed over the serious financial losses suffered through the 2000 market correction by providing near-infinite liquidity. The result, said Lester, was that people borrowed excessively. The world witnessed a boom built on consumer resilience that was, in turn, built on debt.

A financial crisis is usually preceded by “an underlying societal change of consumption,” said Lester. To support his claim he notes the average American saved 13% of his gross salary (nowadays closer to zero) and weighed 9kg less in the early 1980s than today. Over the same period the number of state casinos licensed in the United States jumped from two to 48 as citizens chased easy money.

We have to add a few more ingredients before the financial crisis recipe is complete. Lester suggests a pinch of moral hazard and a scattering of speculation to top the excessive borrowing and low interest rates already mentioned. The team of chefs preparing this lethal cocktail of economic ingredients include the regulatory authorities. They firmly believed they could use fiscal and monetary policy to avert recession. But they forgot that the entire capitalist system is based on trust and consumer confidence. Lester observed that as soon as “people don’t have the confidence to spend, the system comes to a grinding halt!” With consumers out of the picture it was left to corporations to carry the economy; but they had problems of their own. The crisis raises a number of questions around the efficiency of ‘mark to market’ accounting. As financial services companies ran into difficulty they were forced to ‘swap’ risky assets for cash or more secure assets, said Lester.

What is the likely scenario going forward?

What will the post-crisis world look like? Lester identified five likely developments in the wake of the crisis. The first is a move, by both corporations and individuals, from a culture of consumption to a culture of savings. This trend is already evident in most major statistical series reported on in the US. It’s a ‘spend less save more’ attitude that’s great for the savers; but less healthy for growth.

The second long-term effect will be a return to nationalism. Much of the equity market strength witnessed in recent years is attributed to globalisation, the hunt for cheaper goods and higher margins. We’re going to see more ‘Buy America’ and ‘British cars for British people’ sentiment as countries try to rebuild their economies from within. Item three on the list is the comeback of red tape. Regulation is inevitable in the Western economies where so much money has been pumped into struggling industries. These companies will soon learn that billion dollar bailouts come with plenty of strings attached.

Lester says the fourth development will be a period of lower growth. The World Bank and United Nations have already made major downward revisions for world growth in 2009 and beyond. This lower growth will remain with us for quite some time. And finally, there’s a remote chance of serious social unrest as poorer economies struggle to recover. China has often been mentioned in this regard. More than 20 million workers have lost jobs in the industrialised zones and forced to move back to rural areas.

How will South Africa fare?

Over the last decade South African savers have become accustomed to unnaturally high equity market returns. Lester noted that the 10-yr median annual return across the retirement savings industry was 17.8% versus inflation of 5.7%. Over five years the median return was 18.5% against 6.2% average annual inflation. But 2008 brought everyone down to earth. Funds performed dismally, down 11.8% in a year when inflation topped 9.5%. “We borrowed too much from the future!” said Lester, warning the industry to bank on more realistic returns as world economies shrug off recession.

Editor’s thoughts:
Bull market rallies are great; but they tend to lull investors into a false sense of security. After four or five years of positive returns we start believing equities can only climb higher… And that’s when we make the mistake of stuffing our portfolios full of riskier assets. Are you happy with your pension fund performed through the turbulent market conditions in 2008? Add your comments below, or send them to gareth@fanews.co.za