Rudi's View | Aug 23 2007
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck, editor FNArena
A further weakening US dollar. Gold ready to surge above US$700/oz. Global interest rates on the rise. The Australian dollar on its way to cross US$0.90. Global economic growth at 4%-plus.
All these assumptions may have looked highly plausible until three weeks ago, and many an investor will have positioned himself in line with them, but the world has changed in a little over ten days. What seemed highly likely yesterday may no longer be today, let alone tomorrow.
It may have yet to sink in with most investors, but in the past weeks a new chapter in modern history was written. In years from now experts and academics will talk about July/August-2007 in the same way as they do now about the Asian meltdown, LTCM and the dot com bust. In years from now hedge fund number “many” will have closed its doors, courts will have decided in class acts and other court cases, and new regulations will likely be in place in Europe, possibly even in the US and other countries.
Newly elected French president Sarkozy has already thrown his weight behind the regulation of currently unregulated hedge funds and financial leverage products only few understand. Already pension funds in the US, and elsewhere, are complaining they were never properly informed about the risks that are attached to the products they invested in. The coming weeks, and months, will see more of such stories come to the surface.
Global share markets have fallen, and partly recovered. Now the re-assessment game has begun. What will be the longer term impact of what initially started as a problem with subprime mortgage loans in the US for global financial markets?
One of the most recognizable effects, for Australian investors, will be on the Australian dollar. Only a few weeks ago the Aussie surged to US$0.88 and experts seemed convinced it wouldn’t be long before the currency would move past the US$0.90. Some were even talking about US$0.95 and possibly parity with the greenback next year.
All that seems far, far away now the contagion of the US subprime problem into global debt markets has triggered a rapid unwinding of the Yen carry trade. The Aussie dollar fell to US$0.76, almost in one swoop last week and so far it has managed to claw its way back to US$0.80. It may still rise further but US$0.90 seems like a long way off.
In fact, currency experts at major banks and brokerages in Australia have already started scaling back their projections. New peak estimates are between US$0.84-0.88 and some are suggesting we may see the Aussie back in the US$0.70s sooner than previously assumed. All this remains with the inclusion of one big unknown: how long will the unwinding of the Yen carry trade last?
For international investors, the most recognizable impact will be on the price of gold. Recent market turmoil saw central banks across the globe provide billions of extra liquidity to the international banking system. The Federal Reserve decided on Friday to lower its discount rate (but not the much more important Fed funds rate) and speculation is rife that further band aids, including the lowering of the funds rate, will follow.
According to market speculation, the Working Group on Financial Markets in the US has been very active recently. This is a special presidential working group, established by Ronald Reagan in 1988, and believed to have the authority to intervene in financial markets, with governments funds, in order to avoid total mayhem.
Normally, in a time like this, gold tends to shine as the safe haven with no liabilities, but it hasn’t over the past few weeks. Investors have sought an explanation in the rapidly drying up of global liquidity, and in the unwinding of leveraged market positions. Many a gold bull is still expecting spot gold to surge to US$750/oz before December. However, the symbolism of the gold price moving significantly higher when other financial markets are in tatters should not be underestimated. It is only logical central bankers are keeping a close eye on gold these days. It is therefore highly unlikely we will see spot gold move beyond US$700/oz anytime soon.
Recent market turmoil has also seen many an economist reversing his view on US interest rates. Those who until a few months ago had been expecting rate cuts later this year have now reverted back to that view. A consensus seems to be forming around two or three US interest rate cuts for a total of 75 basis points by December.
In a conference call with institutional investors this week, economists at Goldman Sachs said they expected the Federal Reserve to announce a rate cut of 50 basis points in September, to be followed by another cut of 25 basis points at the next central bank meeting. Goldman Sachs estimates economic growth in the US and in Europe is likely to be reduced by 0.5% each next year.
Assuming these projections are correct, and including flow-on effects on other economies such as China and Australia, all of a sudden global economic growth in 2008 could potentially fall below the circa 4.3% projected for this year.
It is not difficult to see why global interest rates would no longer go up, but down instead.
Such a scenario remains far from clear cut though, and is based upon the expectation that economic data in the US are likely to disappoint from here on. The optimists among economists believe we should currently be at or near the bottom of the US housing market, which would make aggressive easing by the US Fed unnecessary. Others believe those optimists underestimate the impact from what is yet to come: US$2 trillion in home loans that are waiting to be reset to higher monthly down payments over the next 18 months.
Luckily, this time around we have China whose economy may grow at a lower speed in the year ahead, but it is likely to remain at a very high speed nevertheless. And Australia should be among the beneficiaries of this.
Investors in the share market can draw confidence from a recent survey by analysts at the Royal Bank of Canada (RBC). After studying 11 major crises since 1970, the analysts found that although all these events were all very different in cause, location and impact, the ultimate direction of share markets following these shocks was surprisingly similar.
RBC found that circa three months after the events, the S&P500 index in the US was up a median of 6.6%, it was up 12.6% six months out and 18.9% over the first year. I’d be willing to bet that Australia will do better than the US this time around.
