Financial markets have swung from the panic of September to something far worse, namely a mad stampede towards the exits even as central banks in Group of Seven (G-7) and elsewhere made a concerted effort to put back the Humpty Dumpty of the global financial system.
Textbook financial analysis exists to provide mirth if not outright entertainment in these times, reminding one of Francis Fukuyama and his article on the “end of history” following the collapse of the Soviet Union. Financial markets are famously creatures of habit; what is happening now though represents not so much cyclical behavior as a transitional one. The last time this happened was when the US overtook the fallen imperial superpower (UK) in the decade after World War II.
The emergence of a solitary superpower created significant imbalance in the global equilibrium, in turn causing the push for a multi-polar world with additional centers around China, a resurgent Russia as well as a multitude of pretenders including a hardly cohesive group of Islamic countries and regional superpowers such as Brazil and India.
Today, the end of history comes in a different form, namely the complete overhaul of the risk-taking mechanism in financial markets. The concept of a risk-free asset which underpins asset allocations and is represented in the books by government bonds is itself in question as governments around the world race to bump up their involvement in the financial sector.
My article last week (see Europe’s death by guarantee, Asia Times Online, October 11, 2008) highlighted the downside to European intervention, namely the likelihood of failed government initiatives on the lines of Iceland. In this case, an attempt by the Iceland government to guarantee bank liabilities failed to calm the markets because the amount of such liabilities was seen as excessive for a country of that size. Iceland is hardly the only European sovereign facing this plight though. Presented with deficits in both their finances and their demographic profiles, the countries of Europe appear destined for the trash can; there seems little point in buying their government bonds as exemplars of safety in this environment.
If we add the US to the same mix, which becomes more likely should the fiscal policies of the current administration be followed by the next one, the world of finance will have to confront a generational shift, namely the search for what would represent the benchmark of risk in the new world. The short answer is that it’s not what you’d think.
Red October, again
The historical pattern of market selloffs in October has been followed this year, going by the first few days’ trading. The reasons this time around are a bit more complicated, therefore some background is required. As always, we start with the interventionists, that is, the governments and central banks.
Central bankers mull solutions that seem to be permanently in danger of being overtaken by market behavior. As an example, the 10% rise in US and European stock markets this Monday quickly gave way to the blind selling of the following days which then reversed with the rise on Thursday.
Over the previous weekend, the US government had put another US$250 billion directly into the equity capital of banks, in addition to the $700 billion fund created to buy problematic assets. In doing so, the US was taking a leaf out of the rescue efforts of the UK, which have then been widely copied by other European countries, including most recently Switzerland. On Thursday, it announced a 6 billion Swiss franc equity injection into its largest bank, UBS along with the separation into a distinct entity of some 60 billion Swiss francs in problem loans from the bank.
A selloff in financial markets after all the above efforts can be ascribed to a multitude of factors, some of which I describe below:
Hedge fund hell: The most reviled creatures in the financial world, hedge funds are private pools of capital that invest in markets using a number of specialist strategies including long-short, leverage and so on. They are hard to ignore in the financial markets, representing between one to two thirds of all trading in many market categories including foreign exchange, fixed income and stocks.
The onset of the financial crisis that caused these funds to cut the overall size of assets (deleveraging) along with restrictions on short-selling (see A stone for Chris Cox, Asia Times Online, July 19, 2008) meant that most of these firms ended up selling, despite all the news about government intervention. As parts of their portfolios become stale or less liquid, these funds have to sell other securities creating a perfect storm of self-feeding sales.
In effect, authorities were once again caught fighting the last war rather than the next one. With outflows of $43 billion in September alone, the sector faces continued challenges to the year-end, nary a day going by without a large hedge fund or other closing down.
Lehman and CDS: The collapse of Lehman Brothers last month triggered a wave of concerns in the mammoth market for credit default swaps (CDS) as investors realized that the risk of their financial counterparties blowing up had risen. Following from the defaults of other banks in Europe, a large number of corporate CDOs – the most leveraged part of the CDS market – soon blew up, in turn causing concerns on losses for global investors including Asian banks (the run on a bank in Hong Kong and an attempted one in India were both traced back to fears on losses relating to these investments).
More importantly, the observation that CDS could not adequately hedge investors’ exposures to market risk has created its own wave of panic for financial markets.
Fundamentals dry up: Macroeconomic data from the US and Europe have been horrible in recent days, with basic numbers such as the unemployment data for September in the US (everyone has stopped it calling the employment report), retail sales, consumer confidence and any other marker you choose all coming in below already depressed expectations. This has shifted markets’ fear from the banking sector to the rest of the economy, that is, from Wall Street to Main Street in the parlance of the US presidential hopefuls.
Poor results: Adding fuel to the fire is the constant stream of poor earnings being released for the third quarter by companies. These results, while widely predicted and expected (including on this website) nevertheless caused a lot of consternation among investors. Declining profit momentum for many companies previously unaffected by the crisis has also caused investors to sell off their global investments including those in Asian stock markets.
Government ownership: It turns out that government ownership isn’t quite the panacea that its being billed to be, particularly for the banking system. Under the supervision of government bureaucrats, bankers would likely cut back on risk taking at the exact time when from a macroeconomic perspective they are most required to take risks.
This avoidance of risk has caused many securities, including fixed income, to fall below intrinsic value feeding the current storm in financial markets. At the end of the day, this factor may be seen as the most important constraint facing financial markets today.
BRIC trouble: Most notably the first three countries (Brazil, Russia and India) are in a spot of trouble, with their currencies in free fall against even the weakened US dollar, their banks under pressure for funding and authorities at a complete loss to figure out policy responses. China is embarking on fiscal stimulus, a strange thing in a country running at over 10% growth: this is due to well-founded fears that the overly restrictive monetary and credit policies (a function of the ill-advised currency regime) disallow recovery from the coming export-related slump that could wipe out around 5% of GDP growth by this time next year.
The changing regimes of the BRIC countries point to the challenges for global growth in an environment when both the US and Europe are felled by their decrepit financial systems. For their part, the abrupt fall from grace for the BRIC countries suggests greater focus on fixing their own house. Thus, a China or Russia is unlikely to buy as much of US and European financial risk at a time when their own banks and industrial companies face funding pressures.
Safe haven in sweat and toil
The “end of history” that marked the arrival of a solitary superpower hardly lasted two decades as the reflexive impact of misallocated capital created the mother of all Dutch diseases for the US economy. With its productive capacity virtually eliminated, the US became merely a haven for a bunch of property savants buying and selling an ever-expanding pool of assets with questionable intrinsic value, all the while borrowing from Asian investors to actually fund their living expenses. With that story now finished, investors will have figure out a new safe haven for their assets.
The definition of a safe haven is an asset class that can comfortably support investments by large investors, not necessarily that which is sought by small investors. For the latter group, bank deposits in the Western world serve the purpose of safe havens over the near-term (in most countries), as the scale of government guarantees avoids any chances of losing money until the government itself starts having trouble funding itself.
For those investing multiples of billions though, bank deposits don’t quite cover the idea of a safe haven. Given the parlous state of government finances in the G-7, neither do government bonds. This last statement deserves a little explanation – for the countries of Europe for example, reclaiming the ability to pay off their national debt would entail a significant improvement in their external competitive position. In other words, the prices of products exported by Europe must fall dramatically enough for the rest of the world to be able to buy them.
That in turn means that any investor holding government bonds in these countries will face horrific losses on the foreign exchange component, for example in the value of the euro or the Swiss franc in which these bonds are denominated. This is the catch-22 for Asian investors with respect to Europe: a stable euro (or Swiss franc) means a significant chance of default in future, while a massive decline in the currency would mean a repayment of principal. In effect, there is almost no way for the current purchasing power of these investments to be maintained.
For investments in other countries such as the US and UK, the key dilemma is the lack of export infrastructure on industrial products as these economies have shifted to the services sector. There is no chance that these countries will regain a competitive edge in the export of products anytime soon; therefore they will need to create mechanisms for perpetuating investment flows but without any obvious source of higher returns in future that could help in the repayment. The current stock of securities issued by banks and government agencies (for example, Fannie Mae) represents a financial risk on the property markets of these countries.
Houses do not have an intrinsic value other than their implied rental income. Economies in recession will see rental values drop, therefore the intrinsic value of such properties will continue to decline. Not to put too fine a point to it, this means that up to half of all mortgage securities issued currently have no investment value whatsoever.
Central banks around Asia therefore will have to organically trim their reserves by floating currencies, selling off silly assets such as the agency bonds of the US (Fannie and Freddie) and increasing their allocation to physical commodities such as gold, oil and ferrous metals. Around a quarter of China’s reserves are tied up in these assets, for example, creating a mammoth series of losses in future if they are not sold off.
The world’s overall capacity utilization is declining, suggesting a continuation of deflationary impact on asset prices over the near-term. In effect, buying securities in Europe and the US will only expose Asian investors to further losses. The hardworking citizens of Asia have both a productive and financial edge over their Western counterparts. For them to choose to invest in each other though would take a bit of time, as well as the development of financial markets in these countries.
Strange as this may seem, it appears to me that the only safe haven in the world, aside from physical gold, is investing in financial assets that best capture the global shift of production and consumption to Asia. In effect, the sweat, blood and toil of Asian workers is the sole engine of global growth. Investments could take the form of stocks or bonds, but the geographical constant remains the region. The reason that is a strange choice is that most such funds are managed and domiciled in the financial centers of New York and London rather than Hong Kong or Singapore.
Isn’t it time to complete the overhaul of global finance by moving the centers of management to these Asian cities?