DABERIAM XXXIII

August 2007

Last month I commented that we were at the beginning of the silly season, we are now well into it. While a credit crisis has been brewing for some time, the actual crisis - to mix metaphors - the blue touch paper was lit by Bear Sterns, who appeared naked in the market by admitting they had come unstuck with a fund, whose gearing beggars belief. 

The natural high volatility of the period took a turn for the extreme and it is in the extremes that the fault lines are revealed. The lamest of all excuses are appearing regularly; that what is happening is a once in 10,000 years event. From the comments it would appear that there are a lot of bright stars in the financial world who were apparently only born yesterday. But such is the normal situation when excess becomes the norm in financial markets. The blame this time looks as though it will be heaped on the rating agencies, not the “sophisticated” buyers of structured debt instruments and other high octane investments. 

Central Bank tightening usually continues until there is a crisis and we now have one. The lack of confidence in the credit markets will take some time to unwind. The effect on the US housing and property market where mortgages of any kind have become unavailable has yet to move across the Atlantic into the UK and European markets. One can expect among others, one big German bank and one of the UK banks, probably one that was once a Building Society to discover they have a funding black hole. For some time these old institutions have found it easier to borrow money “in the markets” rather than from high street depositors, who require a little bit of servicing, something that is in short supply in the banking industry.

The Central Banks around the world have so far performed excellently in providing liquidity to reduce the panic in the institutional markets but we can expect to see over the next six to nine months some large holes appear in the balance sheets of some well known financial institutions.

The perverse effect in the short term of the unwinding of borrowing excesses will be for share prices in good sound companies to be driven down as funds are forced to generate liquidity from the only assets they can sell. This will probably include the driving down of commodity prices; for example, many Hedge Funds have very long positions in commodities such as oil. On the other side the same funds that were short, predictably bad companies will have to cover, so driving up their share prices, leading to more extreme volatility. 

Underlying the blood bath, however, is the inexorable growth in the Asian economies led by China. While there is a lot of noise in the markets around the world, the underlying signal is economic growth in Asia, which is unlikely to be derailed by excesses in the western financial markets. 

Interest rates in the short term will be pushed down by Central Banks to deal with the current liquidity crisis but the long term upward trends in commodity prices and the inexorable rise in the price of goods from Asia is likely to continue. The upward trend in interest rates will resume next year when the markets have stabilised, bringing to an end the period of cheap money that has favoured the recent growth in structured products.

Anyone needing to borrow money in the short term is going to find it a painful experience, a reverse of the trend of the last five years. Having said that, well run businesses that have good management who understand their industries will continue to prosper. The pain will be experienced by industries who have indulged or been forced to indulge in financial engineering to puff up their profitability. Expect companies who have fallen to the private equity tigers to have a particularly torrid time.

It will be an interesting world while the excesses of financial engineering are burned off and there are certainly some more financial train-wrecks around, but the medium term outlook is on the whole rather clearer than it was earlier on this year! The Asian tigers will become the clear drivers of the world economy.

Damon de Laszlo 
August 2007