Is this a cancer - or a bad bout of flu?

Markets should remain sickly for some time to come, but it's not a complete catastrophe. Martin Spring looks at how investors' increased aversion to risk could create some interesting opportunities.

The crisis that began in the dodgiest sector of global finance mortgage lending to high-risk borrowers in the US is now spreading to other sectors, and across the globe.

Central banks are providing emergency assistance to financial institutions -- Europe's pumped out the equivalent of nearly $100 billion in a single day. A handful of investment funds have been wiped out by collapsing asset values, while others have frozen withdrawals by their investors. Stock markets have fallen in response to spreading nervousness.

I have lived through the experience of several times of panic in investment markets, such as those of 1987's Black October, when Wall Street plunged 30 per cent, the New York hedge fund panic of 1998, and the bursting of the tech stocks bubble in 2000. To me, the current turmoil in the investment world has the smell of crisis but not of impending catastrophe.

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At present we are being subjected to a barrage of comforting propaganda from government policymakers and financial institutions telling us not to worry, and not to cash in our investments. But they would, wouldn't they? They all have a vested interest in promoting optimism in the face of what one outspoken critic has described as a global financial system that "most resembles a body ravaged by spreading cancer."

Because of its scale and nature, this isn't a crisis that it going to end in just a few weeks. In fact, it probably has several years to run. Things are likely to get much worse before conditions stabilize and provide a foundation for a renewed bull market. For these reasons

- There is too much uncertainty about dodgy credits, which is going to limit availability of credit and raise its cost except for the strongest borrowers. To a considerable extent, lenders are going to be ultra-cautious.

Uncertainty raises the cost of borrowing because it makes it harder for lenders and intermediaries to assess risks, so they tend to price credits conservatively.

There are two major areas of uncertainty in the current crisis.

One is about who has invested in the dud credits and the extent to which they are at risk. Sub-prime and other poor-quality loans are buried in packages where they have been combined with quality credits. Those packages have been bought for portfolios that are widely distributed throughout the world's investment institutions. No one not even financial regulators has comprehensive knowledge of who is exposed to major financial risk because they own too much of the dud stuff.

And there is too much uncertainty about the value of the dud credits. Values are set by trading. Where there are no buyers, as is now the case for most of the dodgiest credits, valuation becomes a matter of opinion rather than established precedent. In the developing credit environment, opinion is generally going to be very conservative.

Because much of the bad news about investment in dud credits will remain hidden from sight for a while, and only trickle out, that uncertainty will keep a damper on sentiment for many months to come.

- The private equity boom is over. That boom has been a major source of the recent strength of stock markets because private equity groups have been competing for, and bidding up the prices of, companies they want to acquire. This in turn has pushed up the shares of small- and mid-sized firms seen as possible targets for takeover.

The private equity boom has been driven by easy access to cheap credit because "gearing up" has been a key strategy used in corporate restructuring. Those days are over. Especially as this crisis has caught banks with their pants down. They have committed themselves to providing credit for deals in process, but are no longer able to "pass the parcel" to the mugs running investment funds, as in the past. One estimate is that they're on the hook for $300 billion.

Hard times ahead for hedge funds

- The hedge fund boom is probably over, too, because banks will be much less willing to finance activities that are often high-risk and usually lack immediate transparency.

Although some hedge funds are making huge profits out of the current crisis because they bet on its happening many more have been little more than herd-following trackers with exorbitant fees. They will fold as their investors come to the end of lock-up periods and withdraw their cash or what's left of it.

- Stock markets are going to be hit hard because of the damage this crisis is going to do to shares in the financial sector, which accounts for a big proportion of the capitalization and corporate earnings of major markets. In the first half of this year, for example, financial services generated 30 per cent of the profits of America's 500 largest listed companies.

Financial firms have generally been making huge profits in the boom of recent years in an unusually favourable environment: central banks willing to keep credit abundant and cheap, managers of long-term funds hungry for higher-yielding investments, managers of hedge and private equity funds hungry for credit, banks that have behaved irresponsibly perhaps even dishonestly, credit rating agencies incentivized by their fee structure to give unduly favourable ratings, and regulators and politicians (as usual) asleep at the wheel or with their attentions focused on yesterday's problems.

Now the banks are going to be the focus of a tornado of anger from those who invested in their products, embarrassed bureaucrats and a political class capitalizing on the new scandal.

Their profits are going to be hit, their costs forced up, and their lending policies will swing to ultra-cautious, low-margin business.

Investor sentiment will remain hostile to them, and to bubbly residential property sectors in the US and elsewhere, for years to come.

Contagion will spread into the real economy

- The credit drought is going to worsen the developing crisis in the US housing sector, as lenders become less willing to provide mortgage finance and charge much more for doing so. Many loans that were made at initially low interest rates to capture borrowers are due to have their rates re-set at much higher levels over the next couple of years, putting the squeeze on millions of households.

According to one estimate, nearly 60 per cent of the $2.3 trillion of mortgages taken out in the US since 2004 will be reset to monthly payments at least 25 per cent higher.

This will be serious enough in itself in reducing demand for housing and depressing house prices residential real estate and construction services are a significant part of the American economy. But it could be even more serious for private consumption, as home-owners will no longer be able readily to borrow more against the collateral of rising property values to finance their spending, and higher interest costs on their mortgage loans will leave them with less to spend.

Recently American consumers have been accounting for a staggering one-fifth of all growth in the world economy, so any slowdown in the growth of their spending as their personal finances come under pressure is going to have global implications.

The collapse of the infotech sector in 2000 triggered a bear market in global equities that lasted three years. As the financial services and US housing sectors are broader-based, their collapse is potentially more dangerous.

However, not all the news is gloomy. There are some positive factors in the global investment environment that give hope that damage will be limited and catastrophe such as the collapses of the early 30s and 70s avoided.

- Central banks have already shown they can be counted to act vigorously to provide abundant cheap credit to prevent a systemic crisis. Although they may well permit some smaller players to implode, pour encourager les autres, you can be sure they will find ways to prevent any major bankruptcy that could threaten the global financial system with seizure.

(Although some do argue, as did former Fed chairman Paul Volcker when the Fed intervened to prevent the collapse of the LTCM hedge fund in 1998, that it isn't a good idea to shield even big players from the consequences of foolish management, as it encourages them to lend irresponsibly and take even larger risks in future).

- The wide dispersion of dodgy credits throughout the world means that they are a tiny proportion of the total holdings of most investment funds. They will take a hit, but for nearly all it will be a relatively small one. The embarrassing losses will encourage more conservative asset selection -- not a bad thing.

- Damage to equity markets will be limited to sectors and companies directly affected. Outside those, the corporate sector is enjoying strong earnings and earnings growth. Balance sheets are sound, debt levels are not excessive, cash flows are strong and yields are reasonable.

- Although the US economy will be hit hard by the problems of the financial services and housing sectors personal consumption growth has already fallen sharply -- it seems probable that recession can be avoided because of America's fundamental strengths. If there is a recession, it's not likely to be unduly harsh, or sustained.

- Increasingly, growth in the global economy is being driven by growth in Asia. Even though slowdown in the US will have a negative impact on Asian exports, the impact will be limited, and easily neutralized by reactive stimulation of domestic demand.

- Although the dodgy debt crisis will impact negatively, the other engines of credit creation will continue to pump out abundant cheap money central banks (especially Japan's, with its ultra-low interest-rate policy), China's massive foreign trade surplus, and the continuing forex surpluses of many exporting countries.

- Huge amounts of savings will need to be invested somewhere, underpinning demand for lower-risk assets. For example, Morgan Stanley predicts that sovereign wealth funds those investing the ballooning state-owned surpluses of countries such as Qatar could grow to about $12 trillion by 2015.

Crises such as the one that has developed in global finance in recent months do not end quickly. They tend to be sustained by their cumulative effects. One of the most important is the development of negative sentiment among investors, who cut their losses, opt for more conservative strategies, and vow never to return to sectors or strategies where they have been burned.

The snowball effect is greater where there are accompanying unrelated negative factors in this case, a cyclical slowdown in the US economy marked by falling productivity and corporate earnings growth, and the prospect of similar slackening in China's economy due to capacity restraints, inflation, and the ending of the one-off stimulus from the 2008 Olympics.

To sum up: I think international investors are going to be in for a rough time for the next year or two.

Now for the good news

However, the developing revulsion against high risk is going to provide interesting opportunities for protecting your wealth, and even making profits:

- Gold and the other precious metals have been notably resilient in this crisis, as one would expect. The worse the crisis in global finance becomes or is perceived to become, because central banks seem to be panicking the better that will be for assets that are no one's liabilities and are rarely held in geared vehicles.

- Other commodity sectors particularly energy and the agriculturals are also resilient because steady demand growth and the many difficulties in expanding production are underpinning their markets. As investments they are no longer dominated by cyclical factors, such as the prospect of slackening industrial production, and in many cases the shares offer attractive yields.

- Equity markets are likely to see collapsing earnings in financial services, highly-geared companies facing refinancing problems, and less investor interest in the shares of midsized firms that have been takeover prospects.

On the other hand, it looks as if the time has come once again for blue chips the well-managed multinationals whose shares are currently still on moderate valuations. They are likely to be a prime target for a new generation of risk-averse investors, especially the big institutional and sovereign funds.

- Asia cannot avoid the "leash effect" of following the trend on Wall Street. But that effect is likely to be weaker than in the past as investors realize that the region has its own internal and increasingly important dynamism, and is largely insulated against American nasties high-risk credit and housing-market collapse.

The next bullish cycle in global equities is likely to be Asia-led, with many of the best investment opportunities in that region.

- In the short term, at least, the long-term sovereign bonds of major nations should benefit from an institutional investor flight to quality. I find it particularly intriguing that while treasuries, gilts and bunds have been in bear trends in recent years, Japanese government 20-year bonds have trended sideways, despite offering yields only in the 2 to 2 per cent range.

- Although real estate looks like a busted flush in the English-speaking nations and some others such as Spain, that is not true of countries where there are still shortages, yields remain attractive, and/or property continues to be viewed as disconnected from market trends in other major asset classes.

Troubled times and a climate of fear always offer interesting investment opportunities.

By Martin Spring in On Target, a private newsletter on global strategy