Events are occurring at such a tempo it is understandable the implication in terms of the big picture and for both the short and longer term are difficult to comprehend. The root cause of the events of the past few days is still in the reckless Sub Prime mortgage lending by American Banks. The Banking crisis and credit crunch those actions precipitated has been exacerbated by the concurrent rise in inflation of energy and food prices in particular and essential goods and services in general which in turn have caused a rise in inflation and a slowdown in economic activity.
The extreme bubble in the residential property markets in the USA, UK and parts of Europe has burst due to the severe reduction in credit and lending. The levels they had reached were unsustainable and again achieved by lenders being reckless and borrowers believing house prices would only ever go up.The key to a recovery in the US is the restoration of mortgage lending and lower interest rates. It is to ensure that will happen that the US Government effectively nationalised Fannie Mae and Freddie Mac which provide around 50% of US mortgage lending.
Over the past several months, Banks in the UK and elsewhere have been raising funds by Rights Issues and other means to replace the capital lost due to their speculation in the US Sub Prime mortgage market. However it has been clear for some time that not all such institutions will survive as independent businesses. The strong will and the weaker will not, that is how capitalism works. Bear Stearns was an early casualty, Lehman Brothers appeared to take the view they would survive because of who they were. When it became clear they could not the US authorities refused to intervene, quite rightly. The result is a shock but there will be an orderly break up of its business, as is already happening. It will pass to the stronger players in the market, and Barclays have been quick to act.
In the UK we have already seen the Building Society market consolidating further and now there is news that Lloyds TSB will acquire HBOS. Therefore there is not complete anarchy as might appear to be the case and not all Banking Institutions are in the same financial state. On Monday a group of leading International Banks pledged $70bn to a liquidity fund to assist in an orderly resolution of issues arising from Lehman’s collapse.
What we have now seen is the rescue of AIG by a loan of $85bn from the Federal Reserve secured by a majority equity stake. The reason why more American public funds were committed was because of AIG’s key role in the proper working of global financial markets. In other words the situation was not equivalent to that of Lehman Brothers. Could other banks collapse or be taken over? That is quite possible, even quite likely. There are as always various rumours in circulation. Smaller banks are now more vulnerable to speculation that may or may not be unfounded. Some may have to be taken over as a result. The market does not however believe a High Street Bank is going to fail. In the US and Europe it is possible another Investment Bank may not survive.
What is happening in the economy?
Inflation is expected to fall quite soon and quite quickly. The price of oil has fallen back by 35% from its summer high and as growth slows so does the demand for commodities. The chart on this page highlights the rapid rise of oil, energy and wheat prices as well as the equally rapid decline since July. As inflation falls interest rates will be reduced which will assist economic recovery.
How do today’s events affect your personal portfolio and what is our strategy to mitigate the negative impact?
The first step in our investment process is to identify your risk profile and risk tolerance which is achieved by the FinaMetrica questionnaire. As a result the risk/reward balance of your portfolio should reflect your personal tolerances. We then have a strategic ten year view of the local and global economies which is contributed by Michael Hughes CBE, formerly Chief Investment Officer at Barings Asset Management and now a Consultant to Fiducia. This enables us to identify the best asset allocation mix for each portfolio style. In order to take proper account of the short term economic outlook we make tactical adjustments to the longer term strategic view and these are reviewed when our Investment Committee meets each month. As a result our outlook and expectations are realistic. However, we cannot avoid systemic market risk, as in this case, despite the application of sound portfolio management principles.
The portfolios include a wide range of asset classes such as bonds, fixed income, property, absolute return funds, funds of Hedge funds, private equity, commodities as well as traditional long only equities. Our research is active and ongoing enabling us to add assets that are non-correlated to the movement of equities which are of benefit in difficult times such as these. Going forward we will continue to propose adjustments as the market dynamics change.
In terms of the future outlook our views have not changed. We believe the prospects for the emerging markets are more encouraging than for the UK, USA and Europe. Most emerging economies are in good shape – growth is strong, public and corporate finances are healthy and the demographics are in their favour (young consumer populations). The latest research estimates the emerging markets will account for over 60% of global GDP in 2009.
We also see opportunities in Private Equity because Bank lending will be cautious and restricted in the aftermath of recent events. Private Equity has accumulated vast sums of capital and will be able to cherry pick the best deals.
Infrastructure projects again mainly in the emerging markets will still be attractive investment propositions such as power, water, roads, airports etc.
Also as the economic cycle moves forward, commercial property will become attractive due to the extent prices have fallen. Markets are very resilient and while current events quite rightly appear extreme even in historical terms, global and local economies will be in better shape for the long term without the without the distortions created by credit and borrowing that has been far too freely available.