Capital Rules OK!
David Miller - 25.11.08
“We are in a period when market time is running a lot faster than normal time. It is essential to take advantage of opportunities as they occur through active management. Post event rationalisations can wait for less exciting times.” - 12th August 2008
Little did I know when I wrote this three months ago that we were about to enter a period of such extreme volatility - see chart below. This event is most definitely not ‘post’, but some things are becoming clearer and so some ‘rationalisation’ seems appropriate.
Volatility 1995 - 2008
Source: Bloomberg
Capital has become incredibly valuable. To illustrate perhaps I can use the numbers presented by a successful hedge fund manager at a recent conference. At the start of 2008 this particular fund had a balance sheet, including leverage, of $100 billion. Since then borrowings have been repaid and the balance sheet has been reduced to $20billion of which $18billion is in cash. To achieve the stated return objective, the manager is using only $2bn compared to $100bn at the start of the year. Year to date the fund is up over 20%.
There is a strong message here for all investors. During periods of extreme volatility we need to adjust exposure to risk in proportion to the return that we expect. After years of cheap money, during which time investors of all types including developed and emerging countries, individuals ranging from billionaires to ‘Joe the plumber’ and companies, all borrowed to spend, expand, acquire, refinance and cover up mistakes. The real value of capital has now multiplied time and time again and the virtual circle driven by liquid credit markets has turned vicious in just a few months.
With each successive rescue package that has been announced, the amount of money committed has increased until TARP was passed into law with $700bn of US tax payers money. Surely this would be enough was the consensus view at the time. Not in my opinion, although recently I did receive a report that quoted a number that seemed at least to be of the right order of magnitude and that was $15trillion which is similar to US Gross National Product. This number is not an estimate of the losses that banks have made, but is a credible attempt to quantify the amount of risk capital being removed from financial markets as the banks sort out the excessive lending of the last few years. Now that could explain the way in which markets have been behaving. Hedge funds may be forced sellers, but this is a side issue. As Bill Clinton might have said, ‘It’s the banks, stupid’.
I said earlier that some things have become clearer. In summary;
(a) A number of leading banks have wiped out their capital. However, governments have made it clear that they will do everything possible to protect savers and keep the banking system functioning. This is good news, but watch out for any loss of nerve by the authorities as they face up to multiple bank recapitalisations.
(b) We have entered a recession which will be deep and last for several years.
(c) There will be a sharp fall in the rate of inflation and we may even see a negative number next year.
(d) Interest rates will fall further and faster than seemed possible just a few months ago.
Armed with this it is possible to identify sensible investment themes that have a reasonable chance of success in this new, rather tough, environment. It is also possible to identify investment solutions that should be avoided.
Given the level of uncertainty, the value of capital and the huge range of attractive opportunities available it makes no sense to lock up capital in less liquid investments. For example, those who a year ago invested in five year capital guaranteed structured notes backed by a bank whose credit rating is now deteriorating, will attest to how uncomfortable they feel at present and how much poorer they are in the short term.
Borrowing to invest even though interest rates are falling is simply unnecessary and potentially dangerous.
Backward looking asset allocation models (see my February note, Spurious Accuracy, Precision and Psychometric testing) have failed to protect investors. Ten year average returns and past correlations have been of little use this year and I would argue they will continue to provide poor guidance for a number of years to come.
Governments are fully occupied at present in an exercise that may best be described as battlefield triage of the financial system whilst at the same time trying to work out how to sustain the rest of the economy and the morale of consumers. As soon as there is a break in the bad news they will move swiftly on to a search for explanations as to what went wrong and finally who to blame.
Investors should have a different agenda. Liquidity in all asset classes is critical so that when the forced selling stops and the markets calm down investors will be able to deploy their very valuable capital to maximum effect. There are attractive opportunities in all asset classes.
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