News

01/12/2008 - Living in Limbo

Though the panic in financial markets appears to have subsided we are presently living in a state of limbo. This suspended
animation consists broadly of four stages:-
a) The inauguration of the Obama Administration will only take place on January 20th 2009. Though the incumbent Bush Administration is working to achieve an orderly and effective handover, no decisions of significant consequence will take place in the next 2 months. Mr Obama is putting together a team of considerable experience and competence who are, no doubt, preparing appropriate policies to address the major problems facing the USA, both
domestically and internationally. The expectation placed on the shoulders of Mr Obama and his team is immense and probably unsustainable.

b) Our period in limbo is extended as we wait for the commercial banks to lend again. At the moment, they are transfixed by the prospect of further write-downs of toxic loans and the probability that some commercial enterprises,
other than financial services and property companies, will be unable to repay loans as global growth contracts in 2009. The same paralysis is now evident in the market for letters of credit which finances much of world trade. Unless
the log jam is broken soon the seizure will ensure that the recession in 2009 will be increasingly severe.

c) We are reduced to a further period of waiting in limbo as the experts continue to revise downwards their estimates for global and regional economic growth in 2009. The OECD has just released its bi-annual Economic Outlook. Their
estimates for annual growth in real GDP for 2009 are as follows: USA -0.9%, Eurozone -0.6% and Japan -0.1%. This compares with the estimates for 2008 prepared by Consensus Economics of USA 1.4%, UK 0.9%, Japan 0.6%
and the Eurozone 1.0%.

d) Earnings estimates for 2009:
It is currently impossible to say what these numbers will be until (a) – (c) are more clearly defined and understood.

Suffice to say that analysts are scrambling to reduce their forecasts in the belated knowledge that investors view them with justifiable scepticism; given the huge conflicts of interest that flourished in the now discredited banking model which fed the hunger of greedy banks and careless rating agencies with minimal regard for the longer-term interests of their investor clients.

Empty Heads
In a fascinating article in the South China Post (November 22), Andy Xie (independent economist) asks the question – “How can so
many greedy, ruthless and incompetent people be running the world at the same time?” Leadership failures are clearly evident at national treasuries, corporations, central banks and legislative assemblies. The success of globalisation and information technology increased productivity markedly; optimism boomed and low interest rates provoked increased risk appetite, greed and hubris. Risk taking and expansion became the desirable criteria for leadership. But optimism and IQ do not go hand in hand.

Leadership in central banks/financial institutions/corporations has failed to observe normal rules of prudence and true risk diversification. It will be a long and painful process to extract the world from the economic and financial mire in which we are deeply embedded at present. One example of the dangerous legacy our “leaders” have bequeathed us is the total of global credit swaps still outstanding. In 2002 these amounted to USD1.563 trillion. By mid 2008, this number had increased to USD54.611 trillion (ISDA).

Financial Rescue Plans
Since October these have been announced with increasing regularity. Following a round of co-ordinated interest rate reductions the “first wave” included the following: USA - $700 billion, Germany - $645 billion, UK - $400 billion, France - $450 billion,
Netherlands - $250 billion, Russia - $210 billion, Sweden - $190 billion, South Korea - $130 billion, Singapore - $100 billion.
In November China announced a financial package of $600 billion, followed by a further $1.4 trillion produced by the provincial and municipal Governments last week. Then the Federal Reserve pledged up to USD860 billion to help home buyers, small businesses and student to overcome their particular credit crises by providing new loans and buying existing debt. The pre-Budget
proposals in the UK had a similar focus. Of course, the question must be asked: What is the percentage of new fiscal allocations?
Or how much of the enormous sum are actually re-cycled amounts previously earmarked in earlier budgets or Government handouts?
No matter how large the fiscal package is, it is quite clear that planning and executing them will take time.

Currencies
Bank Credit Analyst (BCA) argues that last week’s announcement by the Federal Reserve that it will purchase US$600 billion of
GSE debt/MBS “means that the US is moving to outright debt amortisation”. With US interest rates approaching zero, and the prospect of nominal GDP contraction in the coming months, the aggressive stance of the Federal Reserve (quantitative easing) is
likely to induce weakness in the US dollar in the longer term. BCA suggest that the Euro is the “anti-dollar”. Despite the weakening
economy, and tight credit squeeze, fundamentals support the currency with interest rates in the major G7 economies converging to
Japanese levels. The decline of the yen carry trade will become more noticeable from now on. Sterling is near record lows and it
may be expected to rally post the pre-Budget announcements.
A synchronized global recession is clearly developing and governments are moving to make sure that their currencies remain
competitive. To prevent their currencies rapidly appreciating, policy makers outside the USA must pursue expansionary
programmes, especially those linked to the US$ (eg China). In due course a weaker dollar will be a significant component of global reflation. Sterling is consolidating its losses against the US dollar and the Euro. It has breached the mid-1990’s lows in both
nominal and trade weighted terms. A rally can be expected in this environment. Despite the de facto rationalization of the UK banking system the longer term outlook is relatively grim for the currency.
USA Paul Krugman describes it as “the lame duck economy”. A long period of Republican politics has ended in severe financial and
economic crisis. Though the interregnum will be shorter than that in 1932//33 the stock market crash has been the worst since that
period. Rising unemployment, plunging manufacturing production, dwindling personal consumption and business investment have
been well chronicled. Cash strapped US companies are cutting dividends at the fastest rate since 1958. Despite this the dividend
yield on the S&P 500 @ 3.8% now exceeds that from a 30 year US Treasury. Detroit poses particular problems: should the auto companies be allowed to die, with the loss of 3 million jobs? Or saved and restructured, yet again? The decision cannot be taken by default.
Chris Wood (CLSA) argues that with US$4 trillion in housing wealth, and $9 trillion in stockmarket wealth, destroyed in the USA “we are witnessing a classic debt deflation bust at work; characterized by falling prices, frozen credit markets and plummeting asset values”. The solution is not to just print money to avoid the mistakes of the 1930’s: the Japanese experience of the 1990’s –
persistent deflation despite near 0% interest rates – will not promote the required economic recovery. The Federal Reserve can
control the supply of money, not the velocity: witness the total collapse of securitisation over the past 18 months. The huge
increase in the Federal Reserve balance sheet indicates the severity of the situation. The Keynesian position that an aggressive
fiscal policy, to be paid for by future taxpayers, is the fundamental cure for the threat of deflation is also only partially effective. The
process of deleveraging personal and corporate balance sheets will continue and this inevitably means further consolidation and
failures. To repeat the Japanese experience of a continuation of a large number of uncompetitive companies, and the penalisation of those with savings, would merely encourage the threat of deflation. Mr Bernanke’s well publicized stance on confronting falling
inflation suggests that both short and long term, interest rates will decline further; with the Bank as the last resort buyer of long term Treasury bonds? This policy would not be supportive of the US dollar as debt piles on debt.

China
Jim Walker (Asianomics – November 28th) notes that the last time China cut interest rates by 108 basis points was in 1997 in the
middle of a substantial increase in bad loans for the banking system and a consequent 2 years of recession. The decline in 1 year rates has so far totalled 16%, against 9% in 1997. Deposit rates have been reduced to 2.52% while the current inflation rate is 4%.
Reserve requirements are also down 100bp. He believes it will be fruitless: “Beijing is cheapening capital when too cheap capital lies firmly at the root of its many problems”. The World Bank has lowered its forecast for GDP growth in 2009 to 7.5%. He argues that China has mis-priced capital, the exchange rate and key commodity inputs. China has been part of the global credit boom and
must inevitably be part of the credit bust. The combination of a significant decline in private sector capex, and an export slow–
down and a fall in personal consumption, suggests a GDP number for 2009 which is considerably weaker than most forecasts.
Philip Bowman (IHT – November 26th) concurs. China was overdue a major cyclical downturn: adverse global economic
conditions will exacerbate the structural flaws. Stimulative packages will prevent sudden collapse. Structural issues such as the
extremely high rates of savings and investment and accumulation of exchange assets have produced an increasing income divide
in China and weak consumer demand. Excessive expenditure on extravagant public buildings, high-end housing, corporate
reliance on speculation to generate profits, focus on size rather than return on capital, are other examples quoted. The rectification
of such excess takes time.
Thus the world should not expect too much too quickly as China experiences its first major cyclical downturn since it joined the
global market economy. The authorities have the money and the determination to address matters. In Hong Kong last week the
writer was informed by two separate investment managers, with exceptional experience and track record, that the devastation of
Sichuan (and surrounding provinces) where 60% of the topography has shifted, requires the building of 10 cities of the size of Hong
Kong! There will be further stimulative packages: timing and execution will be critical for the future prosperity of China and the
commodity producing countries, especially in the Asia Pacific regions.

Eurozone
The EU intends to earmark €200 billion to stimulate the faltering economy. This represents about 1.5% of European GDP. The impact may be limited as Germany has already declined to participate with fresh funds. Indeed much of this €200 billion had already been announced. Merely to achieve zero growth in 2009 a fiscal stimulus of 2% of GDP is judged necessary. The ERBD’s annual report published last week has sharply reduced its forecast for GDP growth for the region in 2009 from 5.7% to 3.0%. It aims to increase planned investments by 20% to $9.1 billion. German business confidence slumped to the lowest level in 16 years.
The ECB is expected by cut interest rates by a further 100bp in the near future.

United Kingdom
The £20 billion stimulatory package announced last week in the mini-budget was clearly designed to offset the new forecast of a fall
in 2009 GDP of the order of 0.75% - 1.25%. Borrowing will rise to £78 billion in 2008 and £118 billion in 2009. Public sector net
debt is predicted to rise to 57% in 2013/14. A reduction in VAT from 17.5% to 15% for one year and an increase in the top tax rate to 45% are the other notable features.
Energy & Commodity Prices
The spectacular decline in prices, while causing grief to the companies operating in these sectors, is a significant bonus to
consumers and business alike. It is a substantial tax cut. The decision by BHP Billiton to abort its bid for Rio Tinto clearly illustrates the new reality governing expectations for commodities in the economic recession. In due course, when confidence revives, the
combination of interest rate reductions and falls in energy costs in particular will underpin the next revival in global economic
growth.

Fair Value in Global Equity Markets?
Martin Wolf (FT November 26th) suggests that, “while the global economy is teetering on the brink of the most damaging slowdown
since World War II”, stockmarkets are now attractively priced. Using the Q ratio (developed by Tobin and Smithers - the value of a stock/stockmarket to net assets at replacement cost - and Robert Shiller’s Cape ratio it appears that the US stockmarket has been
in a bear market since 2000 and today’s valuations are well below average for the first time since the late 80’s. For investors, with
long term horizons, the time is right to selectively invest, though valuations may have further to fall as leveraged investors are
forced to continue selling. Governments will also play their role in stabilizing prices, given their deep pockets and ability to take a
longer view.
In Japan core inflation is positive, despite the decline in oil and energy prices. The financial system is in reasonable shape.
Businesses can access credit should they need to. Corporate balance sheets are relatively strong and not leveraged. The Yen has
also been strong. Expect Japanese institutions to be more prominent in Global M&A activities in 2009. Meanwhile the domestic
investors, institutional, and particularly retail, have returned as buyers; though foreigners remain net sellers.

Asset Allocation
The US Dollar and Japanese Yen will remain relatively strong against other major currencies and those from commodity producing
countries. The demand for sovereign bonds remains significant, despite the low yields. Global equities remain oversold and this
fact has underpinned the late November rally. But the economic outlook is still too uncertain for a long-lasting rally to be sustained.

Whereas short-term relative rallies can be expected in the coming weeks, a cyclical momentum decline can also be a feature before the markets finally stabilise and a sold platform for recovery is built.

Disclaimer
This commentary has been prepared for clients and professional associates of FundQuest UK and FundQuest MM Limited and is not intended
for, and must not be distributed to, private investors. This information is supplied to you in confidence and you may not pass it on to any other
party without prior written consent. Past performance is not necessarily a guide to future returns, and changes in rates of exchange between
currencies may cause the value of investments to rise or fall. Derivatives can be highly volatile and such investments may carry a high risk of
loss. No representation or warranty is given (express or implied) as to the accuracy, completeness or correctness of the information nor the
opinions, interpretations and conclusions contained in this commentary. The commentary does not constitute investment advice nor a
recommendation to purchase or sell any security. Neither the author nor FundQuest UK and FundQuest MM Limited accept any liability
whatsoever for any loss or damage arising in any way from any use of or reliance placed on the commentary. FundQuest UK Limited and
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