The Credit Crunch - Our View and the Market Outlook
We have recently witnessed the biggest fall in the value of investments generally since the Great Depression of the 1930’s.
With the exception of Government Loan stocks (Gilts), all the asset classes commonly held by or on behalf of private investors and savers have suffered severely, regardless of their nominal risk rating. Shares, company loan stocks (corporate bonds), and commercial property have all fallen.
We conclude therefore that there has been a ‘bubble’ in such investments similar to that in residential property prices.
Following the crash, a number of explanations have been advanced. While it is likely that all have contributed, it is their combination that has so devastated markets and economies worldwide: -
- Slack monetary policy (low interest rates), resulted in the growth of too-easy, too-cheap credit, which, while maintaining a buoyant consumer boom for several years and increased living standards for many, also encouraged a wave of activity in the capital markets and in mergers and acquisitions;
- Private Equity firms, fuelled by cheap finance, borrowed heavily to buy out publicly listed companies, commonly leaving the balance sheets of those companies loaded with debt. Many are no longer able to carry the burden of that debt or to re-finance it as it falls due;
- The Executive Directors of companies became carried away by their own hubris (over-confidence) and indulged in reckless acquisitions. The Directors of RBOS being a prime example - they bet the bank;
- The emergence of sophisticated financial instruments, typically collateralised (secured) on mortgages, credit-card debt, car loans etc., in which the originators maintained no stake (and thus no risk), but which were traded globally, little understood, if at all, by bank directors or regulators. A well-known US investor described such instruments as ‘weapons of financial mass destruction’ and so they have proved – threatening the very solvency of countries and creating a worldwide collapse in confidence and a slump in international trade;
- The power of modern computing provided trading platforms with a hitherto unknown speed and efficiency in processing transactions. However, it also enabled extraordinary growth in the level of speculative trading transactions, eventually reaching unimaginable volumes. (Sadly, the flip side of free-markets, which are otherwise so efficient in allocating capital, promoting trade and improving the distribution of goods and services, is exploitation by speculators.);
- Feeble corporate governance - the failure of non-executive Board Members to properly represent the interests of shareholders as against the interests of the Executive Directors (the company managers);
- An almost total failure by those charged with the oversight of the markets to discharge their responsibilities. Governmental complacency, weak banking supervision, and ineffectual regulators - all are in the frame for contributing to the construction on a grand scale of the proverbial ‘House of Cards’. It has now collapsed spectacularly.
The combination of cheap credit, seemingly endless liquidity, the readily tradeable new securities devised by the money markets and a determination by traders and investors, banks and financial institutions in particular, not to be left behind, spurred on demand for all asset classes, artificially boosting prices and over-valuing target companies. A rising tide lifting all boats, no particular skill was required to make profitable investments. Or so it seemed. In fact it was the ‘irrational exuberance’ of which a former US Federal Bank chairman warned some years previously. It gave rise to a huge expansion of the financial services sector, with own City of London in the vanguard. It turned out to be a ‘paper economy’.
By way of knock-on, reduced demand and capital flows from the West as governments, investors and consumers alike retrench in the face of recession, have caused those falls to be mirrored to a greater or lesser extent in the developed areas of the Far East and in the Emerging Economies. Few countries have escaped unscathed, although the particular impact varies by country. Thus for example the exporting countries are suffering as a result of the collapse in demand by importing nations, itself largely brought about by a dramatic fall in credit availability as banks frantically seek to shrink their loan books.
Government borrowing on a truly impressive scale to stave off actual economic collapse is likely to ensure higher levels of taxation for decades to meet the interest charges and repayments falling due on the new national debt burden. With the loss of confidence by investors and consumer anxiety, only a slow return of confidence and growth may be expected. Consequently, we do not anticipate an early return to recent asset valuations.
That however is not a reason not to invest, but rather it is recognition that we are where we are, regardless of how the markets arrived at this position.
Equities, commercial property and corporate loan stocks will continue to be an essential part of the savings and investment scene and should remain the home for an appropriate part of any savings portfolio in the normal way.
The outlook for real returns on cash on deposit in the banks and building societies is now mixed. They may be negative if interest is earned at 1 to 2 % or thereabouts when inflation runs at 3 to 4%. To put it another way, savings held in deposits would be worth less in a year’s time than they are today. On the other hand the Retail Prices Index (RPI) was up only 0.1% in the year to January 2009. But then again, sterling is likely to weaken as our national debt grows, increasing the price of the many imported goods upon which we rely. And there is further inflation risk in the UK Government’s policy of ‘quantitative easing’ – a euphemism for creating money.
We shall therefore be continuing to advise that a sensible proportion of savings should be invested in such assets, having regard at all times to the particular circumstances of the client concerned, their attitude to risk and the purposes for which the savings are intended.
The implications for investors vary according to their circumstances. For those with long savings horizons, recent events are only a ‘reality check’, requiring careful re-consideration of expectations. For those approaching or in retirement the issues may be altogether more urgent.
Should you have a need for advice please contact our Financial Planner, Mr Will Patterson, at our Dumfries Office in the first instance.