Highlights & lowlights of 2008

Market Review

WHAT HAPPENED?

The roots of last year’s extraordinary events stretch back almost a decade; grounded in the lax lending that followed the last bear market of 2000-03 and the repeal of the Glass-Steagall Act in 1999, which prevented commercial banks from getting involved in investment banking. In the wake of the dot.com bubble and the terror attacks of September 11th in 2001, interest rates were kept artificially low to support growth. However, what developed during this period was a blasé attitude towards risk, misplaced beliefs that modern capital markets had become more advanced and that the securitisation of debt would spread the risks.

As a result, when the first subprime defaults started to emerge, there was a widespread assumption that the pain would be easily absorbed — after all, subprime debt was a relatively small part of total mortgage lending and a fraction of the banks’ total capital. However, as with every financial crisis throughout history, the promise of easy money was accompanied by a collapse in lending standards. Through complex derivative structures these loans were repackaged, borrowed against and sold on time and time again, fuelling a derivatives market which, by the middle of 2008, had spiralled to $684 trillion* –
12 times greater than global GDP in 2007.**

As rating agencies, integral in building up the façade, started downgrading previously highly-rated debt, prices tumbled and the trust and liquidity evaporated. Investment vehicles responsible for repackaging these loans lost their ability to raise capital and turned to the banks for assistance. This squeezed the banks’ balance sheets at a time when they were facing their own losses and finding it nearly impossible to trade loans.

In March 2008, Bear Stearns was bailed out by rival JP Morgan whilst Fannie Mae, Freddie Mac and Citigroup found solace in the ‘too big to fail’ camp. However, Lehman Brothers, Bradford & Bingley and the Icelandic trio of Landsbanki, Kaupthing and Glitnir found no such luxury and all fell victims to the crunch.

Against this backdrop, the first fund sector to suffer during 2008 was equity income funds — an area largely dependent on the fortunes of the banks. More surprising perhaps, was the overall resilience of the FTSE during the first half of 2008 — emphasising the duality of the Index but, with hindsight, also a warning of the more pronounced sell-off that was to occur later.

The trend for growth stocks outperforming income-biased funds continued at pace during the first half of 2008. As the banking system started to falter, speculative funds flowed out of equities seeking returns elsewhere. The commodities bubble drove up the price of both hard and soft commodities to record levels. Whilst in the short run the rise in oil price, peaking at just under $150 per barrel in July and resource stocks papered over the cracks — like every bubble it was destined to burst.

A BLACK AUTUMN

As the full extent of the deleveraging of the financial system began to bite, banks became increasingly reluctant to lend to speculative investors and so the spiral of declining asset classes spread beyond equities and into the commodities and bond markets. The dash for cash meant everything that could be sold off was and the old adage “the only thing to increase in a falling market is correlation” prevailed. It was this secondary, more pronounced sell off in markets during the fourth quarter that most affected portfolios. Unlike the early stages of 2008, when resource stocks provided support for the faltering banks, the banks were in no position to return the favour.

Since the end of the Second World War the most important measure of value has been the yield gap — comparing the payout on 10 year gilts vs. the dividend on equities (see graph top right). Throughout the post war era equities have only yielded more than gilts on a handful of occasions, most recently in March 2003, the nadir of the last bear market. On 18th September 2008 this crossover happened once more. However, far from providing a boost to equities, at time of writing, prices continued to fall and the yield on the FTSE All Share now stands at 5.1% compared to 3.6% on 10 year government stock. By the end of 2008, on virtually every conventional metric, equity appears cheap, with the FTSE- 100 on a prospective price to earnings ratio of eight times and bond yields at a 50 year low.

The traditional basis for valuing assets has broken down and we now have valuations not seen for many decades. However, it is also fair to say the face of capitalism has changed forever. The era of high debt has gone for good and without freely-flowing credit the visibility surrounding profits will continue to be opaque. The persistence of the yield gap and the low price to earnings ratio may be in anticipation of a significant cut in earnings and dividends. A 50% drop in earnings, not inconceivable, would put the market back on a multiple of 16x earnings, approximately the long-term average.

A YEAR TO REMEMBER

2008 will be remembered as a year of intervention — a year in which in excess of $10 trillion was committed to prevent an economic cardiac arrest. In the UK alone the £20bn stimulus package has driven the budget deficit up to 8% of GDP. Whilst in the US, the $8 trillion set aside in the last year alone is (inflation adjusted) twice the total spend on World War Two, or 16 times the amount spent on the New Deal following the Great Depression. What odds for a Glass-Steagall mark two?

Yet despite the many analogies, 2008 was very different to 1929. The availability of credit increased not decreased and whilst unemployment is undoubtedly rising and output falling, we’re some considerable way off the 30% unemployment levels reached during the Great Depression. With base rates now at 1.5%, equity income and corporate debt have recently started to find favour. Whilst 2008 will no doubt be remembered as the year the financial system went to the brink, in years to come it could be renowned for setting in place the foundations for once-in-a-generation opportunities.

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