Although there is plenty of money available to solve the current crisis trillions of dollars in pension, insurance and sovereign wealth funds managers are largely unwilling to use it to buy credits that seem cheap, because they have a nasty feeling they could get even cheaper. "Every time you buy anything, it is worth less the next day," moaned one fund manager.
The "sovereign welfare funds," as Christopher Wood, the strategist at investment bank CLSA Asia-Pacific, calls them, have already suffered the painful experience of buying into major banks because they seemed to offer cheap, once-in-a-lifetime opportunity, only to see billions of dollars of value in their investments evaporate within weeks.
Judging by the latest estimates of financial experts, the credit crisis has a lot further to run. One study suggests that write-offs of bad debts in the US alone could reach $600 billion and knock-on effects $900 billion.
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That's enough to cut 1 to 1 percentage points off economic growth, without even taking into account the wider effects of falling house prices. Increasingly, borrowers who owe more than their homes are worth are just walking away from their debts. They call it "jingle mail" the borrower posts the keys to the lender. Eventually as many as 20 million American families could fall into "negative equity" having mortgage liabilities greater than the value of their houses.
The recent rally
Nevertheless, it seems likely to me and some other analysts that the current bounce in the stock and credit markets and loss of upward momentum in commodities could be the start of something important. Not of new bull markets, but of a major rally in ongoing bear markets. In other words, a bull trap.
The rally should provide an opportunity to sell more dollars and the other unattractive assets you're still holding, at better prices. You can then buy more of the ones that remain in long-term bull trends, such as precious metals and other commodities.
The Wall Street Journal rightly suggested recently: "The stock market may rally, until it once again decides that easier money can't remedy what is fundamentally a problem of bank solvency.
"That problem can only be resolved by financial institutions and regulators coming to grips with the losses, raising more capital to cushion the blow, and closing or selling those banks that can never recover." The most important reason why the crisis is likely to worsen is continuing uncertainty.
Lenders can't value their assets because credit markets are paralyzed, or seriously distorted by temporary factors. Nor can they confidently value banks, funds or financial companies to which they would normally lend because they cannot gauge with accuracy whether they are still solvent.
Borrowing with borrowed money
Investors no longer believe what officials say, because they know the latter all have a major vested interest in promoting optimism. It is going to take several years to sort out this mess restore markets to their normal efficiency, establish realistic valuations, write off losses, shut down the insolvent and recapitalize banks.
The magnitude of the problem is frightening because regulators and governments were asleep at the wheel, allowing the financial services industry to take sound concepts of securitization and gearing to dangerous extremes. "The sheer scale of leverage in the system remains the fundamental problem," says Christopher Wood, the investment strategist who first predicted the sub-prime crisis.
Funds-of-funds resorted to leverage (use of borrowed money to finance asset purchase) "to juice up otherwise mundane investment returns." Increasingly they invested in leveraged hedge funds, which in turn borrowed money from highly-leveraged investment banks.
One of my favourite commentators, Gillian Tett, says banking "has become so complex and opaque in recent years, as a result of financial innovation, that when shocks occur in one obscure corner of finance, this creates all manner of unexpected chain reactions." One example would be how the crisis in dodgy credits hit the value of the soundest ones, because the latter were the easiest to sell if you needed to raise cash in a hurry.
Mike Lenhoff, the chief strategist at Brewin Dolphin, suggests that the Fed may become a buyer of long-term government bonds. Adding to demand for them in this way would have the effect of holding down mortgage rates linked to bond interest rates, which "might help to steady the housing market." Incidentally it would also be politically more acceptable as it would help all borrowers, not just those with the most strained finances.
The growing tide against the free market
Another commentator, John Dizard, suggests that government-sponsored entities such as Fannie Mae and Freddie Mac are likely to be nationalized. They won't be able to raise enough private-sector capital to keep them afloat, while foreign central banks who have invested heavily in their bonds "have made it clear to the US government that it will be held responsible" it has no such legal responsibility, but in practical terms it has no choice.
Recently, Fed chairman Ben Bernanke publicly urged mortgage lenders to write off part of the capital - not just outstanding interest - of troubled mortgage loans. Wood says he "cannot imagine a better way to encourage borrowers to default, and therefore further undermine the solvency of the banking system."
The political consequences of governments being seen ready to commit billions of taxpayers' money to rescue banks, so recently icons of profligate executive compensation, rather than the victims of their greedy behaviour (sub-prime borrowers, pension funds), are also going to be far-reaching and unpleasant.
Taxes or state borrowing are going to have to be increased to meet the huge costs of going to the rescue of the financial system. The burden of bureaucracy on the private sector is going to burgeon, adding to costs and reducing growth.
The inevitable trend towards tighter regulation of the financial system coincides with growing acceptance of the need to impose restraints on a wide range of activity to combat global warming. And a rising tide of hostility to globalization, putting the blame for job losses and other economic problems on foreigners (the two Democrat presidential contenders in the US are showing the way).
There is now "a strong intellectual tide running against free markets and in favour of increased state action," warns the British commentator Roger Bootle.
Where to invest now?
If there is a major rally over the next few months in the dollar and equity markets, generally that hits the prices of assets that have performed so strongly in recent months such as precious and base metals, agricultural commodities and the euro. It should provide an opportunity to buy into such assets, as they still look good for the long haul.
It will also give an opportunity to buy the equities, bonds and currencies of emerging Asian economies. They have strong manufacturing industries, well-capitalized domestic banking systems, and the huge forex reserves and savings ratios that give them the resources to offset troubles in export markets. They can do this by stimulating domestic demand through building infrastructure and encouraging consumer spending.
Many emerging economies are fundamentally sounder
Some of these countries have seen their stock markets hit even harder than those of developed economies. But that reflects a tendency for frightened international investors to bring back home the capital they invested in less-familiar foreign countries, and for domestic investors to go liquid as a reaction to global uncertainties.
I am confident that when it becomes clear that global financial markets are stabilizing, it will also become clear that many emerging economies are fundamentally sounder. They will bounce back much more strongly than those of developed economies with fundamentally inferior growth prospects.
The balance of advantage should then swing away from low-risk assets such as gold and major-nation government bonds towards low-risk growth assets such as well-managed multinationals that have strong brands or abundant natural resources, leading-edge technology development, strong cash flows, low debt and exposure to high-growth emerging economies.
They will be little hurt by the credit crisis and will benefit from a flight to quality as owners of large amounts of capital, such as sovereign wealth, pension and insurance funds, seek to increase their holdings of low-risk assets offering long-term growth.
By Martin Spring for On Target a private newsletter on global strategy
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