FYI | Aug 16 2007
By Chris Shaw
Given share prices have been in an uptrend for a number of years and returns in annual terms have been exceptional for the past few years, many investors relatively new to the market have possibly never experienced a major correction or financial crisis.
With this in mind it is time for an economics lesson on how a financial crisis is created in the first place and subsequently unfolds and what brings it to a conclusion, the lesson coming courtesy of economists Hyman Minsky and Charles Kindleberger in a report on the current market situation provided by Danske Bank chief strategist Teis Knuthsen..
Minsky notes the first requirement of a crisis is a displacement event, which is an exogenous and positive shock to the financial system. He suggests the shock to the system this cycle is either globalisation or the improvement in financial markets over the past decade or a combination of both, as the two factors have contributed to the boom of the past several years.
At some point the boom becomes a state of euphoria, Minsky noting at this time investors are simply speculating rather than investing on any fundamentals. An example here could be the growth in hedge funds in recent years and the runs enjoyed by speculative stocks in the uranium sector of the Australian market in the earlier part of the year despite many of these companies have no possible way of producing unless various state government laws are changed.
Kindleberger notes at the peak of the boom there is almost a balanced state, as insiders are cutting positions, think the float of Platinum Asset Management (PTM), and new speculators are trying to catch up on what they have missed out on.
The next step is a period of financial stress, followed by a rush for liquidity as investors look to dump assets in favour of cash or cash-like investments. Here you can think of the sub-prime crisis and its impact on market confidence.
This rush wakes up the speculators, who on realising the market can’t go higher join the crowd and dump their holdings, forcing a general and widespread sell-off – think equity markets over the past couple of days.
Kindleberger calls the next stage of the crisis the revulsion stage, when banks simply stop lending on the collateral of assets such as stocks or securities. This continues until finally prices fall low enough to bring out bargain hunters in less liquid assets, trade is cut off by limits being set on the size of any decline or the lender of last resort convinces the market there will be enough cash available to meet any requirements.
It could certainly be argued the central banks of the world are attempting the latter at present given the amount of liquidity they have been injecting into their respective banking systems.
So this is the theory behind a financial crisis, but how does this fit into what is going on in markets at the present time?
A week ago Danske Bank had speculated the drawdown on carry trade positions was coming to a close and that investors would soon return to their previous position of seeking and accepting risk in the search for returns.
As Knuthsen notes, that view could hardly have been more wrong as markets are now exhibiting some signs of a secular change with respect to the appetite for risk of investors.
If this is the case it implies the correction will take longer to work its way through the financial system than the bank had previously expected, if indeed it proves to be only a correction and not a financial crisis.
Supporting evidence it is more than a simple correction emerged last week, Knuthsen pointing to the fact what was a sub-prime lending issue has extended into other sectors and is generating major cause for concern, particularly as it has spread into something akin to a run on the banking sector.
The fact the crisis has extended beyond the sub-prime market supports his view it will take longer for some level of confidence to be restored to the market, particularly as while central banks have done their part in adding liquidity to the system the fact remains many investors have leveraged into assets and there is currently (and suddenly) no market for these assets, so there is no way to ascertain what they are worth or for investors to de-leverage their positions.
Knuthsen notes the market is now acting in accordance with Kindleberger’s theory in that there has been rush for cash, banks are refusing to lend when the collateral is financial assets and central banks are pumping in liquidity. The only thing left is assets falling to levels suggesting long-term value, but this is yet to happen in foreign exchange markets in his view.
Even allowing for recent unwinding of the carry trade, Knuthsen notes currency markets have simply returned to their long-term trend levels, so excess has been removed but value has not yet been created.
An example of what could happen if we in fact are in a crisis and not simply a correction can be seen in the Australian dollar-US dollar market, where the current spot price is 83c but purchasing power parity (PPP) suggests a value of 70c. (Purchasing Power Parity is the equalising of exchange rates such that someone in either country could purchase the same basket of goods). As Knuthsen notes this represents a deviation of 18%, so at the peak of 88c last month the Aussie dollar was at its most expensive level ever against the greenback in PPP terms.
Assuming this is being unwound, and Knuthsen notes currencies tend to trade in big cycles from cheap to expensive and back, it would require a further 41% decline in the value of the Australian dollar before it was again cheap compared to the US dollar.
Knuthsen points out PPP on its own is not enough for accurate analysis of currency valuations but it does give a pointer as to what could happen, though again the key is are we in a correction or a crisis?
Assuming the former the currencies that have peaked this year against the US dollar such as the Aussie and Kiwi dollars and the British pound should return to previous highs, but if not there is plenty of scope for further significant falls.
The market may be calling for rate cuts in the US in particular to re-fire up valuations and bring back the boom times, but as Knuthsen notes the central banks may in fact prefer to see value return to markets and assets. If so, the current correction appears far from over.
