COVER FEATURE ARTICLE, NZ LISTENER 23 FEBRUARY 2008

GARETH MORGAN offers insights into the global economy and tips for dealing with a bear market.

Finance company collapses littered New Zealand‘s economic environment last year, making investors and borrowers extra nervous. This year has already seen the start of further market shivers, with world markets down about 11% since the beginning of the year. What are the drivers for the current dive towards recession in the United States, how will the economic boom in Asia – especially China – affect New Zealand, and what‘s a savvy investor to do? Although crystal-gazing is fraught with danger, it’s an addiction especially among professional investors, who are often expected to line up their picks in a beauty parade with their peers.

The public love to pore over pundits’ picks, and many DIY investors will mimic those picks and expect that to set them right for the year. Unfortunately, new information might come to hand a week later and the professional then changes her mind about the prospects of a stock.

Another cold hard fact about investors is that we hate losses more than we enjoy gains. In fact, during bull markets when all shares are rising, investors expect gains on their portfolios and become immune to any excitement when those gains are confirmed. The opposite doesn’t apply, however – during a bear market, when share values are falling, investors find it hard to accept this as “normal”.

Given that the long-term history of sharemarkets shows they go down one year in three, you’d think investors would accept both the ups and downs. They don’t – investor myopia is a permanent disability. When markets are in their weak phase, panic-selling most often accentuates the sell-off, and the worst of the amateur investors always panic-sell at the bottom, lick their wounds for a couple of years and then buy back near the top of the next cycle.

With these cruel realities of investment in mind, you might prefer instead not to think about investment. But sadly, there is nowhere to hide: if you have savings, you have to look after them. Sticking them in the bank is another option, but the long-term reality is that returns from diversified investments are much higher. But even a diversified-portfolio approach entails the ups and downs of outrageous fortune, and it’s the motion sickness from these swings that makes the herd stampede into strategy quicksand.

With these consumer warnings in mind, let’s consider what 2008 portends.

The global economy ebbs and flows

It’s been a ripper, hasn’t it? World growth has been pumping along at rates in excess of 4% for the past four years, and even during the 2000-02 sharemarket meltdown, the world economy grew by a respectable 2%. In fact, the first seven years of this decade have seen world growth 30% above the averages of the 1980s and 90s

 

The wonder of globalisation, which has enabled the economic enfranchisement of millions of poor in Asia and Eastern Europe, has also been reflected in the value of global capital as measured by the world’s sharemarkets.

 

As the world share index illustrates (graph 2, overleaf), over the past 18 years, world shares have shown substantial returns. With the exception of an extremely ugly hole during the 2000-02 crash, investors should be satisfied with an average annual return of almost 9% in US dollar terms or 7% on a NZ dollar basis. Over these years inflation averaged 3% in the US and 2.5% here. The real return of 6% (5.5% in New Zealand terms) each year has ironically been the same average you would find if you looked at world sharemarket performance over the past 80 years. That is, despite the horrendous crash of 2000-02, world shares recovered their performance rates.

Why do markets have the shakes?

To understand why sharemarkets are convulsing now, you have to appreciate the three main drivers of world growth and the investor confidence that underpins it. They are:

• globalisation and the economic liberation of some of the world’s cheapest (and poorest) producers;
• productivity gains through computing and online technological improvements;
• powerful wealth effects from capital gains, with “innovative” lending products underpinning household spending.

The bogeyman that has lurked in the shadows threatening to disturb this nirvana has been the global imbalances, which have grown much larger as we have partied over the last 15 years. They include:

• Some countries have big balance-of-payments deficits, others have equally large surpluses. But these imbalances have been getting steadily larger, making finance from surplus countries more and more critical to fuelling deficit countries’ growth.
• Within the deficit countries, households have been extending their debt in line with the fall in interest rates since 1990. The providers of finance to households have become more and more relaxed about the criteria their customers have to meet. A popular term coined to express just how lax lenders in this area have become refers to the growth in borrowing by NINJAs (no income, no job, no assets).
• Across the world, players in the un-regulated corners of financial markets have borrowed heavily to magnify the wagers they’ve been taking in swaps markets. These wagers are private contracts, much like a bet between two players on the outcome of a football game, that pertain to the future market value of a financial asset.

People have been betting on the market value of large baskets of loans, share prices of companies, values of property portfolios, future values of virtually any publicly traded asset. Every asset these days seems to attract side bets from the swap punters on what its value is going to do. In a swap, one party promises to pay the other a big lump sum if they win the bet, while the other party receives regular cashflow payments in return.

Although the swaps market is a zero-sum-gain – both parties can’t be right – its attraction is that one party gains cashflow and the other takes the risk of a big payout being required. Think of it as a one-armed bandit – lots of little money going down and then, once in a while, a payout.

Once inflation started rising in the 2002-04 period and central banks started to lift interest rates, we expected borrowers to ease off their appetite for debt. The opposite occurred and leverage kept climbing – helped in no small way by lenders further relaxing their requirements on collateral.

With inflation and interest rates continuing to creep up – instead of the normal decrease in inflation as interest rates rise – eventually something had to break. The first victims, finally acknowledging their borrower-customers were unable to service their loans, were those in the sub-prime mortgage market in the US.

Given the sheer size of the debt defaults that lenders have faced, the knock-on to markets beyond the sub-prime mortgage one has been significant. Banks quickly pulled back from other equally risky arenas of leverage. In other words, almost overnight, the appetite of lenders to advance monies to the risky players contracted quite violently. This is the credit crunch.

What we are seeing is the unwinding of these excesses, and not only is the pain being felt by those who borrowed, by their lenders and by the lenders’ lenders, but also by those in the swaps markets who took all those side bets on what value these loans would be worth in the future. Suddenly, some big lump sums are being called up from those who bet that asset prices would keep rising. They can’t pay up. This is known as counterparty risk and it’s come home to roost.

When a borrower can’t service his obligations, he has a problem. When many borrowers can’t, it’s their lenders that have the problem. The lenders include insurance companies and banks. They’re in trouble and are now having to raise funds themselves. This is why you see the Arabs and the Chinese – from the surplus countries of the world, thanks to the oil-price windfall that globalisation has unleashed and having households that don’t spend other people’s money – are becoming major shareholders in US financial institutions.

In New Zealand, we’ve directly felt the impact of the excesses of global debt, as well as climbed aboard the debt-financing bandwagon. The leveraged punters have played the New Zealand story via the “carry trade” – where they have borrowed from a low-interest source such as Japan and punted the proceeds on a high-interest-yielding investment, such as Kiwi dollars. Again, when the frighteners descend and the appetite for risk is pulverised, we can expect punts in exotic little currencies such as our own to be taken off the table.

Will the global boom survive this?

It is often said that if the US sneezes, then the world gets the flu. In other words, the two economies are well and truly coupled. With the economic revolution that is China plus the Europeanisation of the eastern states of the former Soviet Union, it has become popular to believe that decoupling from the US economy is now with us.

Decoupling may be an apt description of the trend, but it is premature to conclude that the US no longer matters. Just look at the spread of the Wall Street wobbles to every sharemarket in the world. The reason for the coupling is twofold:

• US consumers are the world’s most avaricious. This differentiates US consumers from, say, Chinese and Japanese ones, who to date remain most often nervous about their futures and do not spend more than their income or run their debt-servicing bills up so high that they have no free cashflow left.
• The Chinese economy needs America’s just as much as America needs someone to fund its deficit. The US balance of payments deficit requires annual funding equivalent to half the rest of the world’s savings. That’s how much it costs it to fund wars abroad, give election-winning tax cuts and facilitate its consumers’ excess recourse to debt. This morbid mutual dependence takes the form of a trade of Chinese-made goods in return for more and more financial claims on American-owned assets.

What has happened is that the deficit countries, led by the US, have borrowed from other countries to finance their lifestyles. There’s nothing wrong with debt-financing so long as the parties have control of the risks. But now so many can’t service their obligations and are having to surrender assets, including the US banks that wake up one morning with brand new substantial shareholders from the deserts and steppes of Asia on their register.

Where will this settle? Most likely – and remember the markets always overshoot before they settle – with the indebted suitably chastened and poorer for the experience, but the underlying relationship between America and its creditors still very much intact. The hedonistic lifestyle of the West, where high exposure to debt is ingrained, will continue and there will be an ongoing sale of assets to those we’ve found to fund our lifestyle.

There’s a simple relationship in economics that defines how large a balance of payments deficit is sustainable. If the deficit as a share of GDP is no larger than the rate of growth of GDP, then the foreign liabilities to GDP ratio gets no worse. In the absence of any permanent change in the freedom of international capital movement, that gives us a guide. Right now, the comparisons are: the US deficit is 6% and rate of GDP (nominal) growth is 5.5%, New Zealand 8.5% versus 5%, Australia 6% versus 6%, UK 5% versus 4.5%.

As the balance of payments graph illustrates (graph 3, next page), the country with the largest imbalance as per this measure is New Zealand – which makes it relatively vulnerable to its creditors becoming averse to risk. The good news is that our obscenely high deficit is improving right now (as the arrow on the graph shows), thanks to the boom in commodity prices. On the other hand, the UK is looking at an expanding deficit and slowing growth – not a pleasant dynamic.

For New Zealand, then, either that deficit has to shrink or the GDP growth rise – but remember, inflation is already through the “permitted” 3% ceiling. Un-less our creditors become more accommodating, our dollar will have to fall. Generous creditors in a global credit-crunch environment aren’t likely, so our deficit has to keep shrinking if a dollar drop is to be averted. Of course we could always get greater farm production and sell more at these record prices.

But importantly for the world, the US is more or less within the sustainable zone. America’s is the deficit that really matters for us all as it takes up so much of the world’s savings, but with the fall we’ve already seen in the US dollar, plus the likelihood the US is entering recession and its spending on imports will shrink, then, if anything, its deficit will continue to reduce.

The good news coming out of the current financial sector exorcism is that the globalisation boom is unlikely to be knobbled by what’s happening. China and the US will continue their creditor-debtor symbiosis and the rest of us will swing along on the coat-tails of the giants’ economic love affair.

Don’t put the champagne on ice yet

The above is all very well, and supports the notion that what’s gone wrong is that the quality of debt within the US and other economies, just as much as the extent of it, is what’s caused the meltdown. Sub-prime loans are one aspect of this, but as well, the proliferation of structured investment vehicles, which nobody really understands how to price, has thrown lenders into turmoil.

Add to this the fashionable fads of “total absolute return” managers, ramped up performance-fee incentives, concentrated portfolio managers – all ephemeral phenomena of modern financial engineering – and the evidence of speculative mania is compelling. Throw in for good measure the misnamed “hedge” funds and it’s easy to appreciate that the morning after this party could be a humdinger for investors.

There has already been carnage and, who knows, there may well be more. But the end point has to be when lenders regain a level of confidence that reflects full knowledge of the exposure they have to their borrower-clients.

Central banks are already playing their part by easing finance to facilitate orderly workouts from the major imbalances that threaten the financial system’s integrity. Their dilemma is to protect the system but not those who took too large a risk. This area of central bank sanctioning of banks is probably where supervision has been most lax. However, the new Arab and Chinese shareholders will presumably succeed where western central banks have failed.

Sheer momentum of the markets suggests the adjustment will all be over during the next month or two. Financial markets will resume business as usual, albeit more than a little chastened from the excesses of late, and sharemarket investors will be collectively anticipating good economic results by mid-2008.

The risk has to be that unravelling 10 years of gluttony for debt will leave a bruising that takes a couple of years for the private sector to recover from, gain enough confidence to resume its risk-taking endeavours and then make investments that reap satisfactory returns.

The New Zealand perspective

Apart from the speculative games played with our currency – pushing it to levels well beyond those that underlying interest rate differences would reflect – the area of specific debt excess here at home have included:

• consumer debt taken on by NINJA households – this has partly unwound already and driven finance companies, those who dare to tread where the banks won’t, bust;
• property-related debt both on the part of developers and households generally, as they ignored the rental yields on their investments, concentrating only on the potential for short-term capital gains. Rationalisation of this market has hardly begun and Kiwis don’t believe it is possible for house prices to fall.

The mortgage repayments graph (above right) illustrates that Kiwi households are back to full stretch in terms of the percentage of their income that goes on servicing their mortgage. If interest rates rise again, who you gonna call?

On the bright side, New Zealand continues to benefit greatly from high prices for our commodity products – in particular, dairy and crops. This aspect of globalisation and its ancillary trend of the shift to biofuels is a story made just for New Zealand. Imagine what our balance of payments deficit would be like if we didn’t have this boom in exports – the 9% record for our deficit would have been well and truly broken.

So, what is driving consumer spending and imports in New Zealand if it’s not export-based income increases? The answer is not just a recent willingness by employers to raise wage rates strongly but also debt-financed spending by households collateralised against the higher prices of their houses. As discussed above, the supply of credit has been boosted by those finance companies happy to lend to NINJAs.

With the sharemarket falling and the residential property market soft-to-turning, it’s likely business and investor confidence here will suffer a bruising, which is the case the world over right now. So 2008 is set to be a soft year economy-wise downunder, with the middle six months of the year being the softest. And worsening drought conditions in rural areas threaten to postpone the impact of the commodity-price boom. Lack of water also means a power-supply squeeze is again looming for winter.

Whether that develops into a full-blown recession here is in the lap of the foreign gods of credit, whose loans support our lifestyle. Our baseline expectation is that, by year end, the credit markets will be gingerly out of their foxholes once more and business as “once was normal” will have resumed. The risk I see is that it may take longer.

What does it all mean for investors?

Portfolio investors, who have stashed funds away, expect them to be intact and hopefully enhanced by such time they need to live off them. The key questions are how certain they want to be of their returns, and how soon they want to use their savings.

This is what portfolio investment is about – protecting capital through diversifying across and within the asset classes of cash, bonds and shares (including property), while being clear on the timeframe available until dipping into the stores becomes necessary.

The principles of investment are very simple. Pity the discipline of investors isn’t so predictable. As already mentioned, the whims of investor sentiment are what makes the subject so exciting and lead to markets undershooting and overshooting every so often, providing opportunities for investors unfazed about the cycles of value. And so it will be right now, especially here where a lot of investors new to the game are suddenly in the markets courtesy of KiwiSaver.

The most common free lunch naive investors seek is plenty of upside with no periods when their investments are sinking. Oh, if life could be so simple. When the inevitable downer arrives, these are the investors who exhibit all the self-control of a spooked child and sell at prices well below what the value of their portfolio has been and will again be worth. These are also the Henry-Hindsight investors who invest in last year’s best performing stocks and funds and so are compelled each year to change horses.

As the first graph depicted – despite a 40-50% loss in value a few years ago, the world sharemarkets over the 20 years, including that thrashing, still returned 6% after tax and inflation, the same as it has for almost the past 100 years. Even if we take just the past decade, including the three-year hole, we get the same result – an average annual return after tax and inflation of 6%.

Now, of course, the past isn’t a template for the future, but there’s a very good reason that sharemarkets are resilient like this – they simply reflect the value of the world’s capital used to produce income each year. So long as world economies grow, the value of world capital will rise.

For thinking investors, those current events are no more than the inevitable blow-off of steam that markets do periodically. This is nothing abnormal, and if you can’t bear the thought of having to absorb losses, then the only place for your savings is in the bank. That’s exactly what the naive investors will do and there their savings will stay until stockmarkets resume their long-term trend. These investors will slowly but surely get frustrated with lower returns from bank deposits, building up the gumption to enter the stockmarket again.

So how does a disciplined portfolio investor deal with events like those embroiling sharemarkets right now? They take some – not all – money off the table when markets have had a strong run-up and wait for the inevitable correction (which is under way right now) and then they raise their share weightings markedly when a year like 2008 presents the opportunity.

Add to this managed raising and lowering of the cash/shares mix in your portfolio, the mix across different sectors and investment themes and you have a diversified, wealth-protecting and enhancing programme for your savings.

Hardly rocket science, but it certainly requires a discipline that eludes the bulk of investors. Which is why 70% of all investors – including the so-called pros – fail to make the market average return in any one year. They get beaten by their own emotions of greed and fear.

What are my picks for 2008?

I don’t do picks – I leave that to the stockbrokers and those who reckon they can beat the market average long term by holding just a few stocks in their portfolios. My approach is to focus on the cash/shares mix, overweight some investment themes that we reckon will do better than average, hold a large range of stocks and actively trade the currency mix of our cash holdings.

Entering 2008, we have our cash weightings at the highest level since late 2002, we have the biggest proportion of defensive stocks in the portfolios since 1999, and we continue to trade actively the NZ dollar as it swings around on the end of the battle between fear of risk and the higher interest rates it offers.

Meanwhile, we are working furiously on our shopping list of which sectors and companies to buy before the market confirms it has swung back into recovery. Inevitably, we won’t guess the bottom precisely, any more than one guesses the top of the tops, but the idea is to be mainly right in terms of the cash/shares/bonds mix. As long as we maintain a sufficient number of different shares, exposure to unforeseen events in any one of them will have minimal impact.

We have a feeling that interest rates will have to be cut substantially further in the US (down to 2%), but there’s a problem with inflation that will delay the speed with which the Federal Reserve can do this. Being caught between a rock and a hard place means the US economy could have quite a thumping this time, with stagflation the norm over the next 18 months.

So I wouldn’t be at all surprised to see our portfolios in 12 months’ time containing a historically light holding in the US economy itself. Are we seeing the end of the Roman Empire as indebted America runs out of fuel? I’d say so, but it will be a fade rather than a collapse. That means decoupling is inevitable but not imminent.

Greatest risk? On a global scale, that the orgy of debt collapses more fine financial institutions than we were expecting. For New Zealand, that people refuse to believe the asset we own oodles of – housing – is somehow immune to market forces.

The consequences of global bad debts being greater will be global recession. The consequences of too many Kiwis holding too much housing in their portfolios will be a recession here all of our own making.

Read follow-up NZ Listener Cover Feature Article: Avoiding Armageddon, 18 October 2008