The environment is far murkier than usual. The year 2009 will be worse than 2008.
Faced with a total collapse of the global financial system, the US authorities have been forced to swallow ideology and accept massive government intervention to bail out their financial institutions.
A harrowing week began with the bankruptcy of Lehman Brothers (the largest corporate bankruptcy in history); the unintended consequences of the Lehman bankruptcy were to heighten counterparty risk aversion (no one was too big to fail now) and also drive a large money market mutual fund to break par on its NAV. Money market mutual funds suddenly did not seem to be as safe as once thought, and within a day we saw almost $90 billion get redeemed from these funds (2.6 per cent of total assets). Faced with large redemptions, the money market funds began hoarding cash, and soon the commercial paper market came under stress, putting pressure on the working capital funding of large corporates. For a time treasury yields actually went negative and inter-bank yields soared. There was total risk aversion and fear and nobody seemed willing to trust any counterparty. The whole situation worsened with the nationalisation of AIG, raising concerns on differential treatment vis-à-vis Lehman and market players trying to understand who would be allowed to fail.
Compounding the problem, the shorts began targeting Morgan Stanley and Goldman, as the market questioned the sustainability of the independent investment bank model. Faced with a collapse in their share price, and a huge surge in their cost of default protection, it seemed as if these two banks had no alternative but to find a partner with stable long-term deposits.
Faced with a near collapse of the entire financial system, the US authorities had no choice but to act proactively on a huge scale and abandon the piecemeal institution-specific approach.
What Paulson and Bernanke have proposed is to first of all insure all money market funds so as to stem the redemption pressures and capital loss fears dogging this huge industry. They have in addition asked for authority from the US Congress to buy up approximately $700 billion worth of toxic paper from financial institutions, so as to clean up their balance sheets. This toxic paper will be housed in an entity similar to the RTC (Resolution Trust Corporation), which was effective in resolving the savings and loan financial crisis in the early 90s. By putting the paper in a new government-funded entity, we give the markets time to catch their breath and figure out what these assets are really worth. Today the forced cycle of de-leveraging, instrument complexity and panic are not allowing rational price setting.
These measures have been combined with a temporary ban on short sales on financials, designed to force short-covering and hurt the shorts.
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Financial markets have responded to the measures enthusiastically, with global markets rising strongly over the last two days. The bulls are convinced that we have seen the capitulation that marks a market bottom, and that risk aversion should reduce as the market moves away from pricing in financial system collapse. Most Wall Street strategists have put out strong buy calls after these announcements.
Whether the new measures work will depend on a couple of key issues.
First through reverse auctions, at what price will the toxic stuff be taken off the books of the banks? If it is bought at current prices, then we will have a huge hole in the banks’ balance sheets, which will need to be filled. Where will this capital come from? We are talking of capital needs in hundreds of billions of dollars. While this one-time clean-up will enable the markets to dimension the hole, and stop the relentless quarter-on-quarter spiral of mark-to-market losses, can the markets come up with this quantum of capital? Without the required capital, how will the banks grow their balance sheets and stop the cycle of deleveraging?
Secondly after the bail-out, what type of new regulatory requirements will be imposed on Wall Street? There is no free lunch, and after bringing the whole system to the verge of collapse, we can expect significant regulatory oversight, higher capital requirements and greater disclosures from Wall Street. In the new post bail-out era, RoEs (return on equity), profitability and risk appetite will be fundamentally lower.
Also can markets bottom, when nothing has been done to stop the continued price spiral in property prices? Market experts expect a further 20 per cent fall in real estate values, even from here. None of the measures outlined above addresses this root cause of the bust.
As for whether this marks the turning point for the bear market, it is difficult to say. Undoubtedly, the extreme bear scenarios of everything collapsing are probably no longer relevant, but the fact remains that the US is about to enter a consumer-led recession, and the events of the past week have further damaged consumer confidence. We are in a period of protracted de-leveraging for both lenders and borrowers. The recession is now global, and even risks spreading among the emerging markets. The year 2009 will be worse than 2008. Markets on a cyclically adjusted basis are still not cheap.
Even in the case of the RTC bail-out in the early ’90s, markets bottomed only 12 months after the RTC was set up and the economy took two years to bottom out. While we will definitely get a trading bounce, as the worst case gets priced out, and given the levels of fear and cash, it may be no more then that.
There are still too many unanswered questions. Will such an infusion of liquidity cause inflation to spike or is deflation the bigger fear? Will the dollar get devalued? Will investors demand a higher risk premium for dollar-based assets? If the dollar is devalued, won’t commodities spike again? With such intense government intervention and scrutiny in financial markets, will PE multiples derate? With risk appetite under threat, shall we see continued outflows from the emerging markets?
India also has unanswered questions. Is the market prepared for the inevitable earnings disappointments? How shall we fare in an environment of reduced global capital flows? If commodities spike, won’t stress on the macro resurface? Election uncertainties loom in the months ahead.
The reality is that this is an unprecedented time, and the environment far murkier than usual. While a trading rally is clear, it is to my mind premature to make any statement beyond that. This could turn out to be the bottom, but it is far from being as obvious a buying opportunity, as the bulls make it out to be. While it is probably dangerous to have very high cash levels, I find it difficult to be fully invested, either. Given the volatility and uncertainty, having some cash still seems sensible.