By GRAHAM FROST 07/10/2008
Central banks and governments are falling over themselves to bail out the financial system. The Paulson plan will inject $700bn into banks on top of the $500bn of bailouts already made. In the UK and mainland Europe governments have taken emergency action on banks and building societies-forcing mergers and injecting capital. In Ireland and Greece the governments have issued decrees that no depositors shall lose their money. The US, UK, and Europe have not been so bold but all agree that it’s a good idea that no depositors shall lose money. More importantly, the central banks are supplying hundreds of billions in special liquidity to banks caught short of cash. Yet markets are reacting with dismay and the interbank lending rates have soared as each weekend another bank gets into trouble. What will be enough to stop the malaise?
Past banking crises around the world have shown that piecemeal actions on individual banks don’t work, as the market simply moves on to demolish the next likely casualty. As depositors withdraw cash, a liquidity problem becomes a solvency crisis. So a coordinated policy response is required across geographies and it has to treat the entire banking system in a systematic fashion. Even then, liquidity and solvency problems will remain as bank capital will have shrunk dramatically during the process. Someone has to step up to the plate and provide new capital or banks, undoubtedly facing tougher regulatory requirements, won’t have the wherewithal to expand lending.
As commodity prices tumble in response to recessionary conditions, inflation ceases to be an issue so we can expect a coordinated action to cut official interest rates, perhaps to negative real yields. That’s helpful but not a complete solution. A coordinated recapitalisation of banks is needed and governments may not have much choice but to oblige. Once credibility is restored to the system, interbank lending will recommence and credit markets will get going again. It is too late to avoid an extended period of very poor global economic growth but valuations are discounting a very bad outlook already. Single digit price earnings ratios, dividend yields well in excess of government bonds, and exceptionally attractive yields on corporate investment grade credits, all point to excellent value for longer term investors, in our opinion, as they discount large falls in earnings, dividends, and no economic recovery on the horizon. That does not mean that the fear factor cannot drive markets down further but nobody will ring a bell at the bottom.
If you were told that your house price will fall by 20-30% over the next year or two, would you sell? Probably not, because you have to live somewhere, would face transaction charges, and view it as a long term investment anyway. Furthermore, there is no guarantee that the forecast will prove accurate. If the price fall did occur, and you could afford it, you might actually prefer to buy the property next door instead. Stock and bond investments can be viewed in a similar manner- except they have already adjusted in price.