Feature Stories | Aug 19 2008
By Greg Peel
No one waved a flag to mark the beginning of the global credit crisis. Nor did one particular event, among many, provide the specific catalyst. We all now agree, however, that the credit crisis is at least twelve months old. August was the month in which global stock markets broke in 2007, which prompted the US Federal Reserve to make its first interest rate cut – a “shock and awe” 50 basis points – on the way to many more.
One might argue the crisis began a month earlier, when bankers to two Bear Stearns hedge funds put out feelers into the market for buyers of the funds’ subprime mortgage securities, and were startled by a lack of interest. Or equally one might say the crisis began in February, when global reaction to a brief one-day drop in the Shanghai stock market alerted the world to the extent of existing risky asset positions held on significant leverage.
Standard Chartered’s global strategists suggest the writing was on the wall when subprime losses in the US froze the world’s money markets after several European financial institutions acknowledged losses in their own asset-backed securities portfolios. That was a year ago. “The severity of the losses,” notes Standard Chartered, “broke an already fragile market. Funding for securities dried up and the cost of interbank borrowing soared as banks lost faith in each other”.
With the benefit of hindsight, one might argue that the writing was in fact on the wall many years earlier. Thanks to easy monetary conditions in the US early in the century, fast liquidity growth in China and the Middle East, and the creation of liquidity through financial engineering, the world was “awash with cash”, the analysts note. As is always the case, this money found its way into unproductive “investments” (such as the leveraging of the repackaging of repackaged low quality mortgages), and over-consumption, especially in the US.
Not that it now matters where, what, how or who. The world had thought the US subprime crisis was just a bit of a stumbling block, and the “shock and awe cut” one year ago its solution. Global markets were to reach new highs again before it became apparent perhaps the subprime problems had actually spread more ominously into the wider credit markets, and by January it became all too apparent this was definitely the case.
In a year we have seen the failure of Northern Rock, Bear Stearns and IndyMac, amongst other less publicised, and the potential nationalisation of Fannie Mae and Freddie Mac. Global financial institutions have written down US$500bn to date on the value of credit securities. To put this into perspective, one may recall that the last potential global market catastrophe involved the collapse of Long Term Capital Management ten years earlier, with losses of US$6bn.
When it was finally agreed the credit crisis had become global and far reaching, it was next argued as to whether or not the US would enter a recession. With that debate still unresolved, the wider argument was whether or not a US recession would cause a global recession, as has always been the response in the past. Now that developed market economies outside the US are slowing dramatically, that question may already have been answered. But what of the world’s newest economic machine, China? Well that economy appears to now be slowing as well, and upshot of all of it is commodity prices have also dropped dramatically.
Where is there left to turn? From Australia’s point of view, our financial sector was meant to be immune from the US subprime crisis, but clearly it is not, and China was meant to protect us from a slowdown in the US, which clearly it hasn’t. If we were to lose on financials at least we were going to win on resources, but now that argument seems to be losing traction as well.
Standard Chartered acknowledges credit losses in the Asia-Pacific region have been small, but in the analysts’ monthly global update, which is published in London and has no brief to single out Australia for any special mention, it is noted “…many of the problems we have seen in the US housing market are also present in the Australian housing market, where the slowdown has been delayed by booming commodity markets”.
Those commodity markets are no longer booming.
The root of all problems, or perhaps the manifestation of all problems, lies in the US housing market. The market is over 18% off its 2006 peak according to the Case-Shiller index, but the good news is the rate of house price falls has begun to decelerate in the last month or so. The bad news, however, is there remains an average 11 months worth of houses still unsold, and that figure is still climbing.
It has now become popular to predict that the housing slump will not end until the Case-Shiller index is down by at least 30%. Many an economist has also been warning for some time now that even though the credit crisis moved from subprime mortgages to all mortgages, we haven’t yet felt the next wave of impact in the form of consumer debt, being credit cards and auto loans. The US fiscal stimulus package has helped to provide a delay. Prior to the credit crunch beginning, it was the consumer – inside and outside the US – who was ultimately the most exposed. Corporations across the globe entered the crisis in “sound financial condition”, Standard Chartered suggests, but an increased cost of borrowing, lack of credit availability and falling retail sales are all now taking their toll. As the analysts put it:
“The nature of the credit crisis has gradually evolved over the past year from a pure liquidity logjam, into a broader deleveraging trend as solvency doubts rose, and then, finally, into a broad real economy crisis, not just in the US but across the global economy.”
The indicators are that more abrupt slowing is ahead of us. Standard Chartered expects more Western financial institutions to fail before the dust settles, or at the very least be restructured. Lack of credit will continue to lead to slower economic activity, with Asia moving from “breakneck” to mere solid growth, and the West from slow to no growth. Australia, one assumes, straddles that East/West divide.
When the first signs of a credit problem were apparent, the Fed initially hesitated, but subsequently it has acted aggressively in terms of monetary policy measures – from rate cuts, to discount facilities and the acceptance of wider forms of collateral – and the US government has chimed in with fiscal measures, from tax rebates to mortgage protection plans. The rest of the developed world was too worried about inflation to cut rates, the result of which was a falling US dollar and even higher inflation. It would not now help if the Fed were to cut rates further, as this would only lead to a resumption of the commodity price inflation push, undermining the world’s faith in “fiat” currency and, as Standard Chartered suggests, probably only postpone an inevitable erosion in US living standards anyway.
However, central banks across the rest of the globe, from Europe to Australia and even China, are only now undergoing a “sea-change” in monetary policy thinking. Attention has now turned away from inflation and on to preventing a too-rapid economic slowdown.
The process of unwinding excesses of the last few years will take time, says Standard Chartered, and will probably involve three broad steps. Firstly, liquidity will be reduced. Secondly, insolvencies will increase. Finally, economic activity will fall. We are currently only somewhere between steps one and two. This means economic activity still has some way to fall. Asset deflation and slowing growth will cause inflation to subside, meaning interest rates cuts can be forthcoming. The rest of the world will have to catch up to the US.
“Overall,” the analysts suggest, “the world will be split between the haves and the have-nots. For countries and especially companies with good liquidity, solvency and sound business models there will be great opportunities to buy assets and build businesses. For those without there will be even tougher times ahead.”
The analysts do not provide evaluation of Australia under this scenario, but one could assume the Australian corporate sector would get a reasonable tick, with the exception of specific corporations strangled by high gearing. The Australian consumer, however, is heavily debt laden. The health of the Australian financial sector will be dependent on the outcome for both.
Secular Risk To The Reserve Currency
The world economy had experienced five years of what Standard Chartered describes as “blistering” economic growth. But for the first time since the 1970s, this was achieved at a time of rising inflation. Hence it is now easy to look back and suggest global monetary policy was overly loose. And Asian central banks in particular injected “truly massive” amounts of liquidity into the global system in order to keep their currencies cheap (a lesson learned from the 1997 Asian currency crisis).
The result was extraordinary gains in US interest rate markets (as surplus capital from Asia and the Middle east was ploughed in) and commodity markets (soaring Asian demand). Many in the market were unperturbed, making the perennial mistake that China’s emergence meant “this time it was different”. But veterans of the seventies could see a familiar picture emerging. Milton Friedman was right to say “inflation is always and everywhere a monetary phenomenon”. Excessive monetary supply growth caused bubbles in both the housing and credit markets in the US.
Central banks argued that it was not their job to control asset bubbles, but their loose policies are now responsible for inflation that finally passed on to the consumer level, Standard Chartered notes. Excess liquidity, however, provided for a soaring supply in housing and credit instruments ahead of demand, thus debasing the US dollar, sending other currencies comparatively skyward, and exacerbating the boom in commodities.
Global economic activity has begun to moderate, but at a time when price pressures still remain high – classic stagflation. The result is that neither investors nor cental banks are quite sure what to do, and that uncertainty has fired market volatility, Standard Chartered suggests. “Such volatility typically marks the end of a cyclical trend and that is what we suspect is happening with regard to the US dollar”.
The analysts expect that in the short term, the decade-long fall in the US dollar is now over and a reversal will ensue.
The global imbalance created by emerging China (along with existing Germany and Japan) saw the US running ever larger deficits and Asia ever larger surpluses. That trend is now reversed, and Standard Chartered expects the US deficit to rapidly narrow, and Asian surpluses to rapidly narrow. This means the US consumer will move from being a profligate spender to a cautious saver, while Asians will move from being loyal savers to a new world of spending. Having been sold down heavily, the US dollar has fallen below alternative measures of exchange rate measurement such as “purchasing power parity”. (PPP measures the equivalent cost of, say, buying a litre of milk in different countries while the traditional valuation works purely on interest rate differentials). Hence the US dollar is undervalued. An emerging “age of thrift”, notes Standard Chartered, will be US dollar positive. (The OECD fair value level for the Aussie on PPP at the end of 2007 was US$0.70.)
Irrespective of thriftiness, the pervading belief in the US is that the Fed will have to begin hiking the cash rate before the year is out. This might seem counterintuitive, because (a) financial sector weakness continues and (b) commodity price falls suggest inflation has peaked. However, despite a lower oil price, some analysts still believe inflation will continue to rise in the US – perhaps to double digits by 2009.
The reason is that while the oil price might now be much lower than its US$147/bbl peak, that peak represented a full doubling of the price over twelve months. When the Chinese boom really took off around 2004, oil was at US$30/bbl. Oil could fall back to US$90/bbl in this correction – the price at which it entered 2008 – and still be up 30% for the year. Very few analysts can even see US$100/bbl being breached.
Food prices have followed along with oil prices, and base metals, although well down from their highs, are still much higher than their early-century levels. The prices of iron ore and coal, and subsequently steel, are multiples higher, as all Australians are aware. Inflation levels have accelerated markedly in 2008, but they had been growing quietly for several years. Because China could recycle back cheap goods from expensive commodities, inflation growth was only moderate until recently. Now costs in China are also soaring, and the Chinese government is no longer prepared to support low-margin industry. Export prices have thus risen, because the price of absolutely everything has risen.
Do not, thus, expect inflation to return rapidly back to central bank comfort levels anytime soon. This current commodity price pullback is merely a tease, and retailers can no longer afford to wear rising costs in lower margins. When the oil price stabilises, inflation may well continue to build.
Strength in the US dollar will prove to be, however, a short term cyclical phenomenon, Standard Chartered believes.
The wider secular movement at play in the twenty-first century is towards “multi-polar economic growth”. In the twentieth century there was one pole – the US economy, which at the end of 2007 was still over three times larger than second placed Japan, and four times larger than roughly equal third Germany and China. As consumer, corporate and bank balance sheets in the developed world undergo significant restructuring post credit crunch, in the emerging world economic growth will moderate, but still remain well above the level of developed economies. Asia will remain pro-growth, with focus on inter-regional trade and on domestic demand.
The US will still run a current account deficit, Standard Chartered notes, albeit a smaller one. This will still need to be financed by foreign investment, but where is the world likely to want to put its money? Into the “reserve” currency of a system which has pretty much blown itself up, or into the growth story? The US will have to compete with the emerging world by offering higher yields, and these can only be achieved with a lower US dollar.
The Super-Cycle
Commodity price indices have plunged significantly in August. This has occurred as a result of money shifting out of the commodity story as the investors come to realise that not only are the developed market economies of the world, outside of the US, looking at substantial economic slowdowns, but that growth also appears to be slowing in developing markets as well. The rapid fall in US oil demand has provided the real-world impetus as demand falls below supply. The US accounts for around 35% of global gasoline consumption.
Does this mean the Great Commodity Super-Cycle – the one that was supposed to last for twenty years – is over?
The short answer in no. As noted above, 2008 had seen an extraordinary blip in the commodity price curve which drove the price of benchmark energy to unforeseen levels, and dragged all other commodity prices along with it. While the falls we are now experiencing have been sharp, the likelihood is that commodity prices will stabilise at levels much lower than their peaks, but much higher than prices of twelve months ago. In other words, the trend is still up.
Even coal prices have fallen in spot markets, but then the extraordinary price gains locked in early in 2008 were driven by temporary problems, including snowstorms in China, floods in Australia and power outages in South Africa. Standard Chartered notes these short term issues are largely now resolved, but on a longer term basis the realities exposed by such problems remain. Growing energy consumption at home will mean falling exports from developing economies, and thus prices will remain well supported.
The analysts suggest there has been a key shift in the world’s consumption of energy. Whereas the twentieth century was all about gasoline, the twenty-first century will be an age of diesel. Diesel demand, and jet fuel demand, took over that of gasoline in 2008. While jet fuel demand will continue to temper as a weakening global economy sees less air passengers, the demand for diesel is all about an alternative power source in lieu of coal shortages for power generation. And the world’s drivers are switching to favouring more efficient diesel-powered vehicles over gasoline-powered.
Global oil refineries are set up with a skew towards gasoline, not diesel. This problem was perhaps the leading cause of the recent spike in oil prices, rather than the “rampant speculation” many were so hysterically pointing to. As diesel demand spiked (which included stockpiling from China ahead of the Olympics) the price of crude was pulled up with it. There was not, however, such a shortage of crude that prices were implying.
Standard Chartered notes an estimated one million barrels per day of additional global refining capacity is expected to come on stream by the end of 2008, with diesel making up a third of new production. The demand for diesel will fall from lofty levels of supply constraint given economic weakness. But new production capacity is mostly centred in Asia and the Middle East – where demand growth is strongest – and the input for diesel production is still crude oil. Hence longer term demand for diesel will continue to support higher oil prices.
The prices of grains have also subsided, both through their connection to the oil price (ethanol) and because of harvests and yields improving after a period of droughts and floods across the globe. While grain prices will always be beholden to the weather, Standard Chartered suggests there will be ongoing pressure on acreage and yields as growing populations and growing incomes in developing markets increase the demand for food.
Standard Chartered is most bearish on base metal prices, expecting increased supply to result in market surpluses ahead. The supply increases that most veteran commodities analysts were expecting from about three years ago have begun to impact, at the same time that demand is slowing. So goes the base metal cycle. Nickel, zinc and lead should see increasing supplies, and aluminium’s brief price-hike on Chinese production cutbacks will abate on a substantial rise in market surplus.
Copper and tin will remain in tight supply for the rest of 2008, the analysts suggest, but 2009 should also see a move to surplus in these particular metals. This may seem like a bearish forecast, and very “anti-super-cycle”, but the truth is metals prices are still multiples above levels of earlier in the century. Once again this does not mean the end of that cycle, only a drop back to a more muted longer term trend.
With costs continuing to increase, and funding remaining an issue, one presumes the next step in the commodity cycle-within-the-cycle is for uneconomical and Johnny-come-lately producers to hit the wall, thus pulling back the supply side as well.
And finally there is the matter of gold.
The answer to gold’s price direction from here is simply the flipside of the US dollar argument. While global inflation should remain high, the gold price had run away on the collapsing US dollar and end-of-the-world financial market fears. If the US dollar is to rise in the short term before re-establishing a downward trend, it thus follows that the gold price will remain weak until the US dollar burns itself out again, likely some time in 2009.
Once again, the price of gold has only returned to its level at the beginning of 2008, and is still well above the US$650/oz price of a year ago. When emerging markets began to take off around 2004, gold was at US$400/oz.
Implications for Australian Equities
This is not an issue specifically addressed by Standard Chartered in its report. However, on the basis of macroeconomic forecasts therein, one might assume the following.
The good news is that the commodity super-cycle in not over. A rally in the US dollar should also be positive for US equities, providing an upward influence for Australian equities in the shorter term, with the longer term influence of developing market demand underpinning the future.
The bad news is that equities have yet to necessarily bottom out, given ongoing problems in the financial sector. Such problems will probably be “looked through” later in 2008, encouraged by that stronger greenback. While this might be good news for the Australian financial sector, the overhanging local factor is not one simply of increased corporate failure, but of a housing bubble that has not burst. Australia is not out of any recession woods.
