8 August 2007Volume 1, Issue1
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“Measuring Financial Risk in the Twenty-first Century”
Alan Greenspan, October 14, 1999
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“When will they ever learn? When will they ever learn?”
“Where Have All The Flowers Gone”
© Words and Music by Pete Seeger, 1960
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On what is a rare, gloriously sunny day in this otherwise rainy English summer of 2007, the conventional wisdom amongst the City bulls appears to be just as bright and storm-cloud-free. The markets, one hears, are going through a “case of nerves” due to the continuing “correction” in the US sub-prime market, but once this latest case of hiccups passes (like those experienced in February this year), the upturn will proceed, and we will continue ever onward, tickety-boo.
I find myself thinking “Yes, quite” or, for those of you across the pond, “Yeah, right.”
Reality, from where I sit, is quite different. The problem for the markets is, in a sense, the same as the problem with all summers, English or otherwise – every sunny day must come to an end. As difficult as it is to accept, we are in the dying days of the longest growth spurt in modern times. This record-breaking boom is going, going, gone. Though the markets may rally in the next days and weeks ahead, it will be nothing more than a dead cat bounce. The party is truly over – at least for the foreseeable future.
What, you ask, makes you the harbinger of such apparent gloom and doom?
My answer comes in two parts. First, we need to examine the confluence of four factors in the US with four factors in the UK. Whilst these are seemingly poles apart, they are actually two sides of the same coin and are related to the largest item in an individual’s investment profile – their home.
In the USA
+ The continuing collapse in house prices and housing sales;
+ The concomitant collapse in the sub-prime market;
+ The devaluing of the US dollar and what I see as
+ The continuing shift away from US dollar-based investment.
In the UK
+ The continuing, albeit slowing, rise in home prices & sales;
+ The rise in interest rates;
+ The growing strength of the Sterling, and
+ The cranes
Lest you think I have taken up augury in my off-hours, the cranes I am referring to are those dotting building sites and appearing like a new forest across the London horizon, as well as points north, south, east and west.All eight of these factors can be summed up in this: The battle for ever-increasing return on our monies has caused the average family in the US and UK to overextend themselves both in terms of the amount of indebtedness and the level of risk they have incurred. The difference in the two countries’ markets, one seemingly falling and the other still seemingly booming is simply one of timing. The US reached saturation first but do not be fooled by pundits who tell you “that’s a US phenomenon that won’t happen here” because the UK is not far behind.
Over the last several years, the lack of yield on traditional investment products caused a flight to, rather than away from, higher risk categories. Many individuals in both nations eschewed the options of equity investment in favour of moving up the housing ladder to improve their lot in life (pun intended) and to seek an increased return on their investment. Unlike equities, home purchase (real estate) is viewed traditionally as an investment class that holds its intrinsic value longer than other investments, save cash or precious metals. Given the finite amount of available property, especially in the UK housing market, most investors see it as something that will hold its value and rebound faster than equity markets post a major re-valuing or a crash. (In a poll taken in May 2007, 68 per cent of investors believed property is a good way of saving for their old age.) At least that is the conventional wisdom. Unfortunately, once again our old friend “CW” is wrong. The one sector of a depressed or recessionary economy historically likely to recover most slowly is real estate.
To better understand this issue consider the present cycle. After the 1990-1991 recession in the UK, the overbuilt phase lasted almost 4 years, and then the gradual absorption phase also lasted 3 plus years - both longer than usual. The development boom phase of the late 1990s began about 1998 and lasted 2 plus years. This was followed by an overbuilt phase, which began in late 2000 and lasted through mid-2003, and then transformed into the gradual absorption phase as markets started to soak up their high vacancy levels. In mid-2006 another overbuilt phase commenced that is continuing apace. This is most apparent in commercial development –- the aforementioned cranes -– but is also alive and well in innumerable house building sites throughout the countryside. Based on prior cycles, we would normally see the downturn circa late 2008 or early 2009. However, given rising interest rates and the downturn in equities markets, I believe that this might occur earlier than usual (early to mid 2008).
Why?
For one explanation, look at the situation in personal debt v. savings in the UK:
£10,200
The average amount of unsecured debt owed by 21 million debtors.
£96,648
The average outstanding mortgage debt owed by 11.7 million households.
£606
The average annual savings set aside from the average income per household.
975,000
Buy-to-let mortgages (£42 billion) issued to predominantly “amateur” landlords.
14,000
Homes repossessed in the first six months of 2007, up 30% from 30 June 2006.
125,000
Mortgages in arrears, 1% of all mortgages at 30 June 2007.
1.62
The ratio of household debt to personal income in the U.K., compared with
1.42 in the U.S., 1.36 in Japan and 1.09 in Germany.
Now, envision the amount of liquidity that would be sopped up if a major rupture in the equity markets occurs and financial institutions, feeling the sting of their excessive lending in the form of increased bad debts, need to cut back on financing of all kinds to stem the haemorrhaging.
The exact outcome, lying as it does in the future, is unknowable. However, given the present situation we could face a property devaluation, especially in the South of England, of 15% to 20%. Indeed, if a worst-case scenario played out, the collapse could well be more in line with the 1974 property crash than that of 1992, with prices plummeting 30%.
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“Credit feels like it has just had a bad case of schizophrenia, where a year’s worth of credit volatility has been achieved in a little over 24 hours.”
Alan Ruskin, chief international strategist, RBS Greenwich Capital
© The Financial Times, 31 July 2007.
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“The question plaguing everyone is whether the ‘credit event’ is over or the next shoe has simply not yet dropped.”
TJ Marta, fixed income strategist, RBC Capital Markets.
© The Financial Times, 31 July 2007
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“US and European banks are now trading in the credit derivatives market at levels usually associated with companies rated at “junk” …. although in reality they all carry investment grade ratings. A disjunct of this magnitude is extremely rare.”
Allerton Smith of Moody’s Credit Strategies Group
© The Financial Times, 31 July 2007
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It must be noted that all these quotes preceded a week that saw the average intra-day movements in the Dow Jones Industrials swing by 349 points. The intra-day movement for the last two weeks has averaged a 326 points swing with the month of July witnessing an average intra-day swing of 237 points. By way of comparison, the average intra-day swing for 2006 was 167 points while the five-year intra-day average movement was 96 points. There can be no doubt that we are in a period of hyper-volatility.
After considerable thought, I have a word of advice to individuals looking to invest in the equity markets at this point in the cycle: RUN AWAY!
Quite seriously, nowhere is the danger more immediate to investors than in equities. This is not due to the problems or vagaries of a few names or a few industries or even a few product-based equity issuers (e.g., oil companies). Rather, this is an issue of systemic volatility. In point of fact, the markets are simply too hot to handle.
This has come about through yet another related set of events:
+ The boom in “private equity” buy-outs and buy-ups based on highly leveraged but low interest-rated “junk” debt (fuelled, not in a small part, by the misguided belief that only companies with ever-growing quarterly profits are good investments).
+ The meteoric growth of CDOs, CLOs and other securitised structures, the imprudence or naiveté of their investors, and the initial stages of the dissolution of these products
+ The rapid slowdown in IPOs.
+ The continuing ups and downs in the US economy.
As is shown in the following graph, what the Wall Street Journal calls the “Buyout Boom” has grown by leaps and bounds, more than doubling the 2005 numbers in 2006 and well on the way to a new record in 2007. Highly leveraged deals represent 20%+ of global M&A finance, almost quadruple the percentage just 5 years ago.
The driver of this “boom” has been the ready availability of what, by any definition, can be called cheap credit. The perverse part of all this is that cheap credit was actually brought about by the battle for ever-increasing return on our monies. We have watched as “junk” bond pricing has dropped from the 5% - 10% range over funding costs to as little as 1% over funding costs as more and more money poured into fewer and fewer quality investment opportunities. In addition, what were normal safeguards (for example, “tight” financial covenants) have disappeared from most loan agreements.
Unfortunately, the corollary is that what one borrows, one must pay back. This is the Achilles heel of not only this boom but of this entire cheap-credit-based economy we have lived in all too long. Repayment all hinges on one word – LIQUIDITY.
The markets’ liquidity has been aided by the influx of Asian (read the People’s Republic of China) and Middle Eastern (read the Kingdom of Saudi Arabia) monies being invested first in US Treasuries and more recently in LBOs/Private Equity transactions. However, there are increasing signs that these sources are drying up. Witness the internal arguments in the PRC over its US$3 billion investment in the Blackstone Group, which, at the time of this article, has lost US$590 million in value in 6 weeks. The US bond markets have been depressed for months over the PRC’s increasing movement out of USD-based investments into Sterling and Euro-based products. Couple this with the ongoing arguments in senior circles in the KSA over the fact that their return on investment made in US vehicles is continuing to wane with the ever decreasing value of the US dollar (over the last decade, an estimated 60% of the KSA’s global investments, passive and direct, have been in US government or US market securities) and our liquidity worries only mount
Turning off these and other liquidity taps, whether by raising interest rates as the Bank of England has been doing (which while tempering UK inflation also draws investment away from the US) or by a massive downward market movement (what Chairman Greenspan called in the quote that began this piece “an occurrence of panic”), will result in a drying up of the pool of new investors in housing, equities or other investment vehicles. All of these lead us to the same ending - the music stops and not just someone, but many “someones,” will have to pay the piper.
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“Aunty Em, Aunty Em! It’s a twister!”
Stephen Stucker as “Johnny” in “Airplane” (© Paramount, 1980)
mimicking Judy Garland as ” Dorothy” in “The Wizard of Oz”
(© Warner Brothers, 1939)
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There is an old tale told about a country bumpkin who is taken by his city cousin on a tour of New York City. Having traversed the canyons of Wall Street, seen the wealth of 5th Avenue and Central Park West and been mesmerized by the affluence of the great buildings, public and private, he is led to the 72nd Street Boat Basin to admire the yachts riding high in New York Harbour. After hearing his city cousin relate the various and sundry names of the wealthy bankers and stockbrokers who owned the craft, the country cousin turns to his gentrified relation and asks, naively, “And where are their customers' yachts?"
Call me a cynic, but I believe the recent partial sell-off via IPO by Messrs. Peterson and Schwarzman of Blackstone Group had less to do with offering new investors their first opportunity to share the “kill” than it had to do with insuring that they could cash-out at the top and keep their “yachts” afloat. Of the US$4.7 billion raised, the two founders netted US$2.33 billion, and continue to own close to 28 percent of Blackstone. All that is on top of the $615 million they took out last year. Not bad for an initial investment of US$400,000. Of note is the fact that the Blackstone IPO gave investors units of a limited partnership. These units do not provide their owners with any real control of Blackstone and, indeed, the unit owners specifically waive their legal rights to make claims against the General Partners for any of their actions past, present and future. The owners of these limited partnerships units are literally just along for the ride with Mr. Schwarzman (Mr Peterson is slated to retire at year end) firmly in the driver’s seat.
Henry Kravis announced a similar move to sell common units of “Limited Partner Interest” in KKR on 3 July 2007. The question is two-fold, “Will KKR be able to complete their IPO before the market moves against it? If so, will Louis Gerstner, Leon Black (who held extensive talks with a number of investors in Abu Dhabi in late June with the hopes of raising a capital investment prior to an IPO), Steve Fineburg, David Bonderman & Jim Coulter and the other Private Equity barons want to do or, indeed, be able to do IPOs of their firms before the music stops?”
Truth be told, we have not yet hit the real crunch time. The real test for Private Equity firms and their investment bankers will come in September when an estimated $330 billion in bonds and loans will need to be raised to finance corporate buyouts already announced and in the pipeline. A retreat from these commitments or the failure to raise the funds, save at much higher prices, will have a long-term deleterious effect on this market, not unlike that seen in the post-Milken years.
I believe, and have acted personally on the belief, that all that is left in this current cycle is a sucker's rally. Equities will rise by enough to tempt the last players to invest, or recent sellers to reinvest, and will then dive back down – to what depths I cannot hazard a guess. Sucker’s rallies are like roulette. The croupier will never spin the wheel whilst there is an easy target willing to put money on an inside bet. The reality for the player at the table, or in the market, is that eventually the wheel does stop. and it is the House Percentage that rules.
N.B.
For those of you who have forgotten your classics or are still puzzling over this blog’s title, Cassandra was a Trojan Princess whose beauty caused Apollo to fall in love with her and grant her the gift of prophecy or, more correctly, prescience. However, when she did not return his love, Apollo placed a curse on her so that no one would ever believe her predictions. This would not have been such a big problem if she hadn’t been the one to tell the people of Troy “DON’T BRING THAT HORSE INTO THE CITY!” And did they believe her? Of course not, that’s the whole point! Now, fast forward some 32 centuries and ask yourself the same question, “does anyone want to believe someone who tells them what they don’t want to hear?” Proof that Alphonse Karr was dead right when he said “Plus ça change, plus c’est la même chose!” You’ll have to look that one up yourselves!
Cassandra
© Lord & Associates Limited, 2007
3 comments:
As an amateur follower of the market I read Cassandra Redux with interest. To add to this evocative and interesting review I can only add comments of a general nature.
The cyclic nature of the factors affecting risk is undeniable. What is difficult to predict and quantify is the frequency and magnitude of the elements that go to make up the total. Furthermore these elements may be additive and at other times may be subtractive. The diversity of these elements enables risk takers to move from one to another and provide the basis of a tradeable market. The elements may vary from market to market and from one period to another.
There are factors of a more sustainable and long term nature that afect the market for longer periods. For example, the shortage of suitable land for building will effect housing prices, and may lead to a rethink on building methods, e;g.; replacement of the traditional UK house (single family) with apartment blocks - high-rise or otherwise (already happening - "cranes").
Stock prices are difficult to predict or we would all be millionaires. Short term movement of stock prices may be determined by rumour or fact resulting in an individual or institution buying or selling stock in sufficient quantity to be evident to others. Longer term movement of stock prices is influenced by investors backing a trend which can simply be classified as herd instinct.
Cassandra is pessimistic on the stock market but there are others that stil regard the present situation as a temporary correction. Indeed, it is difficult to accept that global growth is going to be dramatically reduced because of the strong growth in emerging economies such as India, China, Brazil and other high population areas where high spending middle classes are starting to emerge. Indeed it is this growth, as well as the US mortgage market, that may have contributed to the sub-prime crisis.
In conclusion, we need to remember one fact - where the risk is greatest so is opportunity.
Albert Hersom
We share the view that liquidity is drying up. The GCC is currently experiencing a significant adjustment to its economic outlook due to a material increase in revenue from continuing high oil prices. While relative increases in oil revenues have occurred in the past, the current cycle appears different.
Unlike the oil price-driven boom of the 1970s, the current cycle is accompanied by high levels of debt in both the public and private sectors with consequential limitations on their ability to support and sustain domestic economic development. This is encouraging governments in the GCC and MENA to give greater priority to the re-investment of surplus oil revenue within the region, and with additional factors that, relative to the developed regions, increase both the demand pressure as well as the magnitude of the supply challenge. These include:
• Higher-than-world-average population growth;
• Historically low levels of existing infrastructure availability in key capacity sectors
The long-term aim is to re-investment within the GCC to create capacity infrastructure that will, via the multiplier effect, create long-term sustainable economic growth and a permanent and continuous improvement of regional living standards.
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