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‘The
greatest threat at present is deflation, not inflation, and hence
central banks such as the RBA, ECB, BOE and others need to cut
rates.’
The
Pain Report
From
the desk of HFA Asset Management’s Jonathan Pain
HFA
is a Pentad Group preferred fund manager.
Saturday
20th September, 2008
It is
tempting to use the words, historic, unprecedented, incredible,
unbelievable and any other superlative to describe the events of
last week. On Thursday 18th September, the news broke that the US
government would create a Resolution Trust Corporation (RTC) type
entity that would purchase mortgage related securities from banks.
US Treasury Secretary Paulson stated: “The federal government must
implement a program to remove these illiquid assets that are
weighing down our financial institutions and threatening our
economy… I am convinced that this bold approach will cost American
families far less than the alternative – a continuing series of
financial institution failures and frozen credit markets unable to
fund economic expansion”.
In a
week that changed the world we saw Lehman Brothers declare
bankruptcy on Monday, Merrill Lynch acquired by the Bank of
America, with the very visible hand of government marching
Merrill’s down the aisle. We then saw a government takeover of AIG,
the world’s largest insurance company and by Wednesday it looked
like Morgan Stanley would not make it to the end of the week. It
was the breathtaking speed of the process of disintegration that
meant that the US government had to step in to avert a ‘systemic’
failure of the American financial system.
Do not
for a moment think that we were not just hours away from financial
Armageddon. On Wednesday 17th September, the mother of all safe
havens, US 3-Month Treasury bills traded at 2 b.p, yes, two basis
points, and the credit and money markets effectively seized up! So
what is next?
Equity
markets around the world saw some of the strongest two day gains
ever witnessed and it is fair to say that the ‘relief’ rally
underway has further to go. My macro view is that the actions being
proposed (we won’t know all the details until possibly next week)
have averted a ‘systemic’ failure but will not prevent the
inevitable and painful process of credit contraction, that we have
been talking about for a year. As we have said before, we have
commenced the ‘Mother of all credit contractions’.
The
greatest threat at present is defl ation, not inflation, and hence
central banks such as the RBA, ECB, BOE and others need to cut
rates. The proposed action by the US government should be
applauded. I personally feel they took rather a long time about it
and in fact we recommended such action on the 20th August 2007 in a
Pain Report entitled ‘Born in the USA’. The RTC-style proposal does
not stop house prices falling but it buys some time and serves to
‘soften’ the speed of the de-leveraging process, but certainly does
not stop it.
A
couple of issues which intrigue me about all of this are; if the
jolly clever financial engineers at the world’s investment banks,
who created all these nasty toxic mortgage-related securities, do
not know how to value them, how does one expect the government
employees of the U.S.S.A (United Socialist States of America) to
put a price on them. Since they are about to acquire many, many
hundreds of billions of securities, I am fascinated to see the
process by which they price them. Another thought is; if the
current capital write downs and credit losses, since the start of
the crisis, amount to US$519.3 billion then surely as the
securities are purchased by the government, the price at which they
are ‘sold’ will constitute a market price and hence have to be
accounted for. Given the majority of these problem assets have, to
date, been classified as Level 3 assets and too difficult to price
then surely we are looking at the potential for a significant
escalation in losses.
Anyway,
maybe such thoughts are not appropriate right now as we celebrate
the ‘Mother of all financial parties’ and I certainly do not want
to be the one to have to ask the awkward questions about government
deficits and the like. So much easier to simply pay the investment
banking executives vast amounts of money as they lose unprecedented
billions and billions, and leave the trillions and trillions of
debt to the next generation to sort out. Why ruin a good
party?
However,
now is not the time for moralising and philosophizing. Now is the
time to recognise that there are some outstanding valuation
opportunities. We have seen a stunning decline in oil prices from
their US$147 peak and our short term target of a decline to US$100
was, in fact, exceeded and we now feel oil will move higher. The
underlying fundamentals have not changed, namely, the motorisation
of the world’s two most populous nations and the ‘crude reality’
that supply cannot satisfy the inevitable rise in consumption. Good
quality, diversified resource companies such as BHP are currently
trading at insane valuations. Regular readers of this report will
know that I am a long-term believer in this company and have been
for several years.
History
shows us that moments of chaos and panic present wonderful
opportunities.
Markets
like China and Hong Kong look like exceptional long-term value
(This is the first time I have ever recommended Chinese stocks
despite the fact that I have been a big believer in the Chinese
economic story). I still cannot get excited about the US stock
market and given the current P/E ratio is 24 times, it is not
exactly cheap and since I just do not believe the E in the forward
P/E, I cannot bring myself to recommending it. The broad macro view
is that most of the economic pain will be in those countries that
have seen the biggest housing bubbles and the highest levels of
household debt.
On the
currency front, the situation is somewhat more complex. We have
just seen a dramatic rise in the US Dollar as investors ran for the
‘risk exit’, but in fundamental terms, debt, deficits, etc, the US
Dollar must be viewed as a ‘high risk’ currency. I also feel that
many countries in Arabia and Asia have, quite frankly, been shocked
by what they have just witnessed in America. If you were
responsible for $1.9 trillion worth of foreign exchange reserves at
the People’s Bank of China, wouldn’t you want to start reducing
your 65% exposure to the world’s most indebted country? In this
regard, the continuing diversification away from the US Dollar,
which was so rudely interrupted over the last few months, will now
recommence. Our parity forecast for the Australian Dollar was
similarly interrupted by the contagion of risk reduction and, yes
we got, oh so close, reaching .9850 on 15 July. It will be a long
road back to parity but, that, I think, is the long-term
direction.
That
is enough of forecasting from us for the moment. Just one more and
then I must go as it is Saturday night! History shows us that
moments of chaos and panic present wonderful opportunities. Now
that the US Treasury appears to have averted a systemic failure,
there are some extraordinary opportunities in the credit markets,
currency markets and selective equity markets. Those who have best
preserved their client’s capital through these extraordinary times
will best be able to participate in these opportunities.
Sunday
morning, 21st September 2008.
We now
have the text of the plan. The US Treasury has asked Congress for
authority to buy as much as US$700 billion in mortgage related
assets from the nation’s financial institutions. ‘Decisions by the
Secretary pursuant to the authority of this Act are non-reviewable
and committed to agency discretion, and may not be reviewed by any
court of law or an administration agency.’ The Treasury plans to
hire managers to purchase the assets through so called reverse
auctions, seeking the lowest prices, a person briefed on the
proposal said.
It is
believed that the House of Representatives will pass legislation to
implement the plan by the end of next week, and the Senate will act
soon after. In response to questions about the package, George Bush
said the following, ‘I’m sure there are some of my friends out
there that are saying, I thought this guy was a market guy, what
happened to him. My first instinct was to let the market work until
I realised, while being briefed by the experts, how significant
this problem became.’
Not
just your friends, George, not just your friends.
Comrade
George, welcome to the U.S.S.A
All
the best,
Jonathan
Pain
HFA
Chief Investment Strategist
Disclaimer:
HFA Asset Management ABN 25 082 852 364 (HFA) AFS Licence 246747
does not guarantee/warrant, the accuracy/correctness of the
information in this document. This document is not financial
product advice. Neither HFA, its employees and/or agents shall be
liable for any claim resulting from any person relying on such
information. Professional advice should be obtained in respect of
your own particular circumstances. Past Performance and asset
allocation is not a reliable indicator of future
performance.
23rd September
2008 Back
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