Investor Psychology

Eight weeks that changed the world

This column originally appeared in our advisor publication, the Mackenzie Professional, in late November. Mackenzie’s Chief Investment Officer, Norman Raschkowan, summarized the economic events of September and October 2008.

September and October witnessed unprecedented volatility in global capital markets. The unwinding of the global credit bubble has roiled equity, bond and currency markets so severely that consumers, businesses and investors have been traumatized, leaving the world’s economic prospects very different from just three months ago.

“It is important to recognize that we have encountered similar systemic shocks in the past.”

However, it is important to recognize that we have encountered similar systemic shocks in the past, and have emerged chastened but whole. Certainly, the pace of change has been unprecedented, but the magnitude is not; more importantly, the nature of the problem is understood and thus some picture of the future can be divined.

Factors that contributed to the current financial crisis

Since the stock market went into convulsions following the US Administration’s decision to let Lehman Brothers fail, the cause of the present financial crisis has been the subject of countless editorials. Yet, there are important lessons to consider as we sift through the ‘solutions’ being floated by politicians of every persuasion. Certainly, excessive credit creation and rampant financial deregulation were key contributing factors.

Alan Greenspan’s propensity to respond to every economic or financial shock by easing monetary policy has been cited by many as having promoted the excessive use of leverage within the US economy. It should be remembered, however, that Greenspan’s easy money policy also allowed the US economy, and arguably the world economy, to recover promptly after the October 1987 stock market crash, the 1991-92 Savings & Loan collapse, the bursting of the tech bubble in 2000, and the 2001 World Trade Center attack. Criticism is warranted this time in so far as he failed to consider the credit-induced inflation of real estate and stock market valuations in setting interest rate policy.

The elimination of many of the financial system’s safeguards in the interest of “deregulation” merits a greater share of the responsibility for our present travails. Consider, for example, that the Glass-Steagall Act of 1933 which kept Commercial Banks and Investment Banks separate in order to control speculation was repealed in 1999. The resulting explosion of unregulated financial market participants, whether mortgage lenders or hedge funds, created competitive pressures that altered the behaviour of erstwhile prudent banks – they took on greater and greater risks at lower margins and, through creative financial sleight of hand, put these off-balance sheet in order to boost returns on equity.

Consider as well that it was the US Congress that compelled Fannie Mae and Freddie Mac to boost lending to lower quality borrowers. Individuals, chastened by stock market losses as the technology bubble burst, were drawn to residential real estate because ‘no one ever lost money in real estate’, a myth promoted by lenders, politicians and investment bankers.

Politicians, regulators and investors all believed that the securitization of subprime mortgages would reduce the systemic risks associated with excess mortgage credit creation by spreading it out over a broader expanse of the financial landscape, not unlike Inco’s giant smokestack in Sudbury.

“It is in man’s nature to believe that we can overcome risk and other forces of nature through reason and innovation.”

Of course, they believed because it was in their interest to believe, and because it is in man’s nature to believe that we can overcome risk and other forces of nature through reason and innovation. What this innovation did accomplish was to feed a global real estate bubble; like Icarus, housing valuations are now falling back to earth.

A global recession is now inevitable

The global economy and global capital markets are now transitioning from an environment of cheap, abundant credit, to one where the supply of credit is limited and the cost punitive. In recent weeks, PepsiCo secured 10-year bond financing at a cost 420 basis points (bps), or 4.2%, above similar US government debt, a level previously the domain of junk debt. Thus, financing costs have surged even as the willingness of bankers to lend have plunged.

“The impact on consumer and business confidence has been devastating.”

The impact on consumer and business confidence has been devastating, with US consumer spending falling at a 3.1% annual rate in the third quarter, and industrial production off 2.8% in September as businesses cut inventories. The precipitous drop of the Baltic Dry index, an index of freight rates, highlights the broader impact of tighter credit on global trade flows. A global recession is now inevitable.

Political leaders and Central Bankers have recognized this as a global problem, and have undertaken coordinated action to
1) provide liquidity to lubricate the engine of global commerce, and
2) boost the capital base of major banks in order to rebuild confidence in their solvency.

Initiatives taken by the US and other nations

Authorities have recognized that rebuilding confidence is critical if consumers and businesses are to spend and invest in the future. The US has undertaken a number of important initiatives:

• The Federal Deposit Insurance Corporation (FDIC) increased the level of deposit insurance to $250,000 from $100,000
• A guarantee was extended to all US Money Market Funds
• The $700 billion Troubled Asset Relief Plan (“TARP”) was enacted to help bolster bank capital and take toxic, illiquid assets off their books
• The Federal Reserve cut the federal funds rate to 1%

Similar initiatives have been undertaken in other major industrial nations. The beneficial impact of these initiatives has already become evident in the short-term credit markets, where the inter-bank lending rates have fallen over 200 basis points. However, it will still take several months, and a return to more stable capital markets, before we can assess the impact of these programs on broader economic activity.

The intra-day volatility witnessed in equity markets in recent weeks is reminiscent of the price volatility experienced by bond markets in 1981, as investors wondered whether Paul Volcker and other central bankers would succeed in taming inflation. The present equity market volatility may herald a similar watershed event – the rebuilding of personal savings. The last time that US consumers actually reduced their absolute indebtedness was in the 1990-91 recession. A more sustained rebuilding of the savings rate would portend a sluggish rebound in US domestic demand coming out of this recession, but would place the US economy on a firmer footing for the future.

Looking to the future

A healthier respect for credit risk would imply that many ‘alternative’ investment strategies founded on the use of low-cost leverage, such as hedge funds or private equity, will no longer be viable. Investors are also likely to regard index funds more warily as they consider performance on a risk-adjusted basis and see the merit of fundamental analysis – understanding what you are buying.

“Has the market found its bottom yet?”

Has the market found its bottom yet? No one can say. However, many of the landmines have now detonated, and so the risks going forward are few. Perhaps the key risk still to play out is the corporate default cycle. Moody’s has estimated that about 7% of US corporate bonds will default in the coming year; this may prove a conservative estimate given the unprecedented issuance of junk bonds over the past five years. This hurdle will be crossed in the coming months, after which confidence will start to rebuild, and investors will start to commit the ever growing pool of capital currently being parked in money market funds.

Attractive investing opportunities abound

Where will investors find attractive opportunities? In some respects, the capital market carnage has been so broadly based that there is a cornucopia of choice. Stock market valuations are generally the most attractive they have been in years. The large capitalization, blue-chip companies with strong brands that generate excess cash that are favoured by the Mackenzie Ivy team, are particularly attractive in the current environment because they will be able to expand market shares and profitability at the expense of their more capital-constrained brethren.

“Stock market valuations are generally the most attractive they have been in years.”

Companies with superior growth prospects should distinguish themselves in the current moribund economic environment, prompting an expansion of their price/earnings multiples by investors. Such growth stocks are favoured by a number of Mackenzie Universal equity funds, particularly those from Bluewater. Tighter credit conditions have enhanced the yields offered by many income investments. Indeed, the S&P/TSX Composite now offers a dividend yield superior to the interest rate of 10-year government bonds for the first time since the 1950s; the same is true of many European markets.

Funds, like Maxxum, that emphasize large-capitalization companies with strong balance sheets and growing dividends should prove particularly rewarding at this time. And, while corporate bond default risk has increased, the yields offered by quality corporate bonds are now quite compelling, making Mackenzie Sentinel Bond and Mackenzie Sentinel Corporate Bond funds worthy of consideration within non-taxable portfolios.

Resources and emerging markets

Investors with a longer time horizon will certainly find resource and emerging market funds of interest given their sharp price corrections. As global economic growth re-accelerates into 2010 and beyond, the supply constraints experienced in 2006-07 will reassert themselves, driving commodity prices higher. Similarly, demographic trends suggest that Asia’s emerging markets will enjoy superior long-term economic growth which, from current levels, should translate into superior long-term equity returns. The values present in many of these markets are attracting the attention of the Cundill team.

“Experienced investors are not focused on picking the bottom, but rather on acquiring good businesses that will be rewarded by the market recovery that will come.”

We are currently navigating through a period of unprecedented capital market volatility, and economic change. In some respects, the future has never seemed more uncertain – and yet, this is also a time of exciting opportunities. Experienced investors are not focused on picking the bottom, but rather on acquiring good businesses that will be rewarded by the market recovery that will come. A prudent approach is to gradually, selectively, commit funds as opportunities present themselves. This is what Mackenzie’s teams are doing; investors with a three- to five-year time horizon will be rewarded.