Market commentators are prone to the overuse of terms like “unprecedented”, but this time the word is finally appropriate. No sooner had markets started to adjust for the nationalisation of US mortgage guarantors Fannie Mae and Freddie Mac, when investment bank Lehman Brothers was allowed to implode by the US authorities, investment bank Merrill Lynch rushed into the welcoming arms of Bank of America, and insurance giant AIG was effectively nationalised by the US Federal Reserve. The fallout from these events will take some time – months, if not years – to disperse. Not that the UK is exactly immune from the financial storms: it seems increasingly probable that even now a number of UK financial institutions will require either a corporate ‘arranged marriage’ or the nationalisation treatment too.
We have gone beyond a subprime mortgage crisis. We are, let’s face it, in the midst of a global financial crisis. But it is important for investors to differentiate between the risks they face as shareholders in financial institutions and the risks they face as depositors or insurance holders in the larger banks and financial groups. In extremis, shareholders can and will be wiped out, as they have been in the case of Lehman Brothers and the likes of Northern Rock. But banks and insurers obviously hold a special place in the broader economy, and depositors and holders of insurance have every reason to believe that they will, by and large, be made whole in the event of a commercial banking or insurance group’s insolvency. The challenge for the international banking system is that there are very few private entities with either the capital or the willingness to support ailing rivals. The alternative – sovereign wealth funds – will be increasingly unpalatable as suppliers of emergency capital of last resort, particularly during a US election year. Which leaves the taxpayer to bail out the larger and more significant financial firms that are unable to work through their problems in an orderly fashion.
So the financial environment is evidently uncertain. During the 1990-1991 recession, many major banks in the US were effectively insolvent, during a period in which house prices fell by less than 5% from their peak. If a 5% fall in home prices was enough to make the largest US banks effectively insolvent in 1991, as economist Nouriel Roubini asks, what will a 30% fall in US home prices, along with defaults in many other forms of credit, do to major financial institutions this time round ? Economic prospects for the UK are comparably poor, given that our economy is more heavily centred around financial services and the vagaries of the property market.
So we will not retreat into lazy platitudes like “stocks for the long run” or other forms of wishful thinking. This is a tough investment environment and these problems are not going to be resolved quickly. We would emphasise a core defensive focus on the preservation of capital – the likes of cash instruments and government bonds, in other words. There is some good news out there: inflationary pressures are fast abating, which makes both cash and bonds more palatable longer term options. Oil, which was trading at $145 a barrel in July, is now trading below $95. Commodity prices are declining across the board, in line with an anticipated slowdown in global economic growth and consumption. While this is a poor backdrop for equity markets in general – economic growth in G7 markets is likely to be disappointing for some time – by exactly the same token, it is a more promising, and disinflationary, environment for the security offered by ‘AAA’-rated government bonds. High quality investment grade bonds have, in addition, rarely been this cheap relative to government debt.
As in an earlier update (3rd July), we would advise investors even now to reassess their exposure to equity market risk, particularly to more speculative sectors, or to UK domestically focused enterprises such as banks, retailers and homebuilders heavily dependent on trends in UK retail consumption. We would recommend concentrating equity market exposure on a thematic basis, tilted towards quality and scarcity (monopoly providers of essential services like utilities and water, for example). On a longer term basis, prospects for the BRIC economies of Brazil, Russia, India and China, and the emerging economies of Asia generally are probably more favourable now, relative to those for the more mature western economies.
The financial markets are currently in a process of adjusting, rather painfully, to this new and more uncertain environment. The prices of multiple types of assets are reflecting not necessarily radically worse prospects, but forced, distressed selling on the part of many financial institutions and funds as those organisations scramble to raise liquidity. Some superb longer term opportunities will inevitably arise out of the panic.
As before, we would reiterate the significance of a sound, diversified and balanced investment approach. The world is not ending, though certain members of the investment banking community evidently are, as independent entities at any rate.
Originally published at The Price of Everything and reproduced here with the author’s permission.