Money Marketing – Investment thoughts – Stormy Weather

Money Marketing

It has been a turbulent week in the markets. Below we feature some commentary on the situation. It is very difficult to remain calm and unaffected in our investment decisions in such times and we hope some of the comments below give you some pause for thought and the information we need in difficult times. It is becoming clear that there is no right opinion and no accurate forecast – those will only become evident with hindsight and as investors we need to be forward looking. We can only deal with what we know and we can only make decisions based on our current and planned for circumstances, and for each of us those may be different.

“It is always at the darkest moments that you have got to be brave,” David Smith, Chief Investment Director, GAM Multi-Manager.

Director at Investec Asset Management Jeremy Gardiner says that as fund managers, “part of our role is to give some sort of indication to investors as to where we believe the world is going at any given time in order to facilitate investment decision-making. Our market predictions are generally the function of an enormous amount of fundamental analysis, both from our in-house analysts and from analysts from the world’s leading stock broking firms. Of course we are not always going to be right, but given the amount of work that goes into these predictions, we tend to be right more often than we are wrong, which is about as much as one can hope for.

“Obviously, at times like these, short-term predictions are almost impossible. We live in a credit starved world; a world where – particularly for financial services companies – available credit is oxygen. Indeed, for the global economy, credit is oxygen. Run out of oxygen, and you are dead, as with Lehmans. Run short of oxygen, as is currently the case with most of the world’s financial institutions and consumers, and the world economy slows down.

“Of course, if your country’s government decides that it is in the interest of their citizens that an institution doesn’t die, they can provide oxygen, as was the case with Fannie Mae and Freddie Mac. Each death is very traumatic to the system, particularly for those already short of breath, and the worst case scenario is that the contagion spreads and you have a string of collapses that threaten the health of the entire financial system. Fortunately, this is unlikely. What is more likely is that a lack of oxygen in the system will cause corporates, consumers and the global economy to slow.”

Events unfolding in the US reflect a once-in-a lifetime event – an event that has never occurred during the “derivatives era”. So it’s big and its likely final impact is uncertain, says Sanlam Investment Management economist Arthur Kamp.

“The Fed’s decision to leave interest rates unchanged on Tuesday illustrates that authorities do not believe lower interest rates will address the problem. The issue is one of an inability to raise sufficient capital in an environment of de-leveraging and falling asset prices. The Fed appears set on addressing the fall-out by focusing on the provision of liquidity. The potential for further interest rate cuts is dependent on the extent of any further deterioration in real economic growth or slowdown in core inflation.

“It is not an easy task to gauge the likely economic impact of the credit crunch. The failure of Lehman Brothers, an investment bank, is unlikely to do extensive damage to the real economy and the US Treasury was not about to bail out this institution with taxpayers’ money. If a large commercial bank was involved it may well have been different because commercial banks lie at the heart of the economy.”

Alan Greenspan has been quoted as saying that the US (and therefore the world) is experiencing a once-in-a-century financial crisis, says Stanlib’s Group Director of Retail Investing Paul Hansen.

What has gone wrong in financial markets? Hansen says that a long period of rapid economic growth, low inflation, low interest rates and general economic stability bred complacency and increased the willingness of both individuals (property) and financial companies to take risk.  “Rising interest rates in the US burst the residential property bubble two years ago and since then the problems have largely come from this area. An end to the fall in US house prices remains a key to ending the crisis. This has not yet occurred. The sub-prime crisis may not end until the US housing market reaches a more affordable level.

“AIG, one of the biggest insurance companies in the world, is a prime example of the heightened risk-taking. It has many excellent businesses, but in the late 1980’s it formed a new financial business which subsequently wrote billions of dollars of derivatives, which are now at the heart of its woes and are far removed from its core insurance business (FT, 17th Sept). In particular, it began insuring investors against defaults on collateralized debt obligations (CDOs), or pools of securities. This and other similar securities accounted for the bulk of the $41bn dollars written off recently and has led to the US Fed buying almost 80% of its shares and extending a loan facility of $85bn to the company, thereby throwing it a strong life-line.

“It is gratifying to see that not all of these American investment banks have been poorly managed.  Although Goldman Sachs’ third quarter profit fell 70% from last year, it still made a net profit of $845 million in possibly one of the worst quarters in modern history. How? The company is seen to be a class act in risk control, ie its top leadership is excellent.”

“The crisis is not over as long as property prices continue to fall.  This means that uncertainty/risks remain high.  How many other financial companies will fail?   This is impossible to predict, but the probability is fairly high of further failures,” says Hansen.

Says SIMs Kamp, “looking ahead, the question remains whether financial institutions can raise sufficient capital to deal with the fall-out from declining asset prices. If not, and if the potentially adverse impact on financial markets and ultimately the real economy is large enough, one imagines the US government will need to step up to the plate. This, of course holds implications for the level of US debt and ultimately taxpayers.

“Either way it takes time to repair balance sheets (including household balance sheets) and the US economy is likely to remain on the back foot for an extended period. Along with deteriorating growth prospects in the Euro zone and Japan, the impact on emerging markets will be significant, which was already evident well in advance of the latest round of financial turmoil.”

Meanwhile, the net exposure of SA banks to the bankruptcy of Lehman Brothers is likely to be small but it is difficult to quantify the broader impact of the financial crisis on the global and local economy, says Sanlam Investment Management (SIM) senior portfolio manager Patrice Rassou.

“Lehman has been involved in the SA market but fortunately has never been a major participant,” he notes. “In the short-term, Lehman’s bankruptcy and the forced sale of Merrill Lynch to Bank of America could restore a bit of confidence to the financial markets. The most important thing is how long that confidence will hold because if rumours start circulating about other global investment banks there could be further problems.”

Rassou says in South Africa the big banks have indicated they have relatively small direct credit exposure to Lehman. “So net exposure-wise I do not have big concerns.”

From a broader picture perspective, the issue of liquidity comes back on the table. Sentiment is very negative and a drying up in global liquidity would impact on the ability of South African banks with global exposure to do business in developed markets. “The liquidation of investment bank assets could also impact on adjacent asset classes from property through to equity and the likes. Also, if sentiment deteriorates further, the level of activity could slow down on a global scale.

However, he says South Africa is probably in a less precarious position than other emerging markets because the currency was hard hit last year and early this year as a result of Polokwane and the Eskom crisis and has since held its ground through the unfolding global credit crisis. “It looks like having a balance sheet will prove a key competitive advantage in future which should favour commercial banks over investment banks.”

So what should investors be doing?

South African investors should ride out the volatile markets and take a long term view of the investment outlook, says Di Turpin Chief Executive of the Association of Collective Investments.

“We have seen volatile markets before and know that investment prospects will again recover once markets have settled down. After the recent world-wide equity sell-off now is certainly not the time to re-shuffle portfolios.”

Investec’s Gardiner says: “The answer is that there is not much you can do at this stage.  You certainly shouldn’t be fundamentally restructuring your portfolio now.  As we have written before, the time for portfolio restructuring is when markets are calm, not during a hurricane.  Why?  Because if you try and change direction now you will be acting largely on emotional rather than fundamental reasoning, and investment decisions made emotionally generally tend to be wrong. In situations like these investors tend to go against common investment theory, and instead of buying cheap and selling expensive, they sell cheap (out of panic) and buy back more expensively.

“And therein lies the problem.  It is very tempting to sell into cash at this point, and if you (or indeed anyone) were capable of calling the bottom of the market, this approach may be viable.  However, research shows that when markets turn positive and rally, much of the gains are made in the first three months, a period during which most investors are waiting for confirmation that the rally is sustainable.  Cashed-up investors in these phases face the unenviable quandary of piling into a rising market or holding back in the hope of a setback. They usually do the latter, which means that every mild setback is met with a storm of buying.

“Waiting for the low before buying always looks attractive on the way down, but the problems with it are only apparent on the way back up. Selling now to buy back at a lower price is even more difficult – what if the assumption about lower prices is wrong? It is psychologically very difficult to buy back at higher prices, so such a strategy runs the risk of selling at a low and not getting back in.

“There are indeed risks during times like this, but there are also significant opportunities starting to emerge.  You can sit on the side until it feels more comfortable to invest, but when it does feel more comfortable, it may no longer be profitable to do so.”

Hansen says that, “we don’t think now is a time to be selling even though there may be more downside to come. We think it makes sense to be gradually accumulating (perhaps on a monthly basis) both offshore and local equities.

“Stick to your investment plan within your risk profile.  Remember that over the past few months in SA, three of the four asset classes have done well (listed property, bonds and cash).”

Turpin says that the well regulated South African Collective Investment industry has thus far continued to attract net inflows throughout the sub-prime crisis: Net inflows during the June quarter – the most recent period for which statistics are available – were just below the R10 billion mark.

“One of the reasons is that investors realize the long term growth potential and out performance of collective investments.”

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