December 2007 - Liquidity Crisis

Liquidity crisis

The expression "when life gets tough, the tough get going" applies at this moment. We are all well aware of the headlines in newspapers, comments on radio and television and pronouncements from economists, central bankers and market makers that we could be  in the eye of "a perfect storm". The headline of The Independent on Wednesday 5^th December sums it up: banks have stopped lending, consumers are not spending (or actually, some are going to extraordinary lengths to borrow money to continue spending); investors aren't investing (well actually they are and the clever ones could make considerable gains from the current dilemma); businesses are not hiring (probably, but this will not become evident until after the Christmas binge); and houses are not selling (anecdotal evidence suggests the housing market has ground to a halt).

So why haven't equity markets collapsed (yet)?  This is a combination of a range of factors. The globe and its economic system is in completely unchartered territory as a consequence of the dramatic evolution of emerging markets.  Will those countries with all the cash and savings bail out bankrupt western economies?! From selling on sub-prime debt to repackaging policies on dying people in the United States, any number of extra-ordinary instruments are being used to meet the demand for yield in order to satisfy pension funds, pensioners' income requirements, and a maturing and retiring western population that needs income to live on

The dramatic rise in consumption in natural resources and the growth of the economies of emerging markets is putting unbearable strain upon the globe, particularly inflation. The conundrum faced by our own Bank of England about how to control inflation with interest and yet manage the debt crisis is a perfect example.  Markets work on fear and greed.  At the present time, greed still just about has the upper hand, but the whole global economy only moves forward if there is money to spend. The fact is that the money has been spent on over-priced assets and particularly property (primarily domestic property, but also commercial property), whilst at the same time, financial engineering has been used to finance mega mergers and acquisitions which may in time, find it very difficult to service the mountains of debt they have taken on. All debt can only be serviced if consumption can be maintained.  If we all stop consuming or indeed simply reduce our consumption, even by a fairly modest percent, the globe will end up with massive indigestion and this will lead to a significant and severe slow down in economic activity. Figures before us suggest that the reorganisation of debt in the housing market in the United States could hit a peak in March or April next year.  The same is probably true in the UK, and the effect of people having massive increases in mortgage payments, not being able to refinance their credit cards - even the possibility that good credit customers will find their headline limits being reduced - could have extraordinary consequences.

What should you do?

In our view, the boom in equity prices has probably come to an end. The probability of making significant returns on equity anywhere in the world in the foreseeable future, i.e. the next 6-18 months is probably very limited. But we cannot be certain that emerging economies and the cash reserves tied up within will not come to our rescue, and therefore we should continue to have some exposure to equities, natural resources and commodities around the world. Inflation may become a real problem. We see food price inflation in Russia and China, and we see difficulties with economies whose currencies are pegged to the US dollar. Therefore, we believe that there is a reasonable justification for having some low-volatile, reasonably secure index-linked global bond investments which of course are primarily sponsored by governments and therefore should provide significant and reasonable security. The probability of interest rates going up seems to KMG much less likely and eventually they should come down. This combined with an increased appetite for low-risk investments suggests that a high weighting in government stocks particularly in the UK (gilts) should be part of everybody's balanced portfolio for the next few months.

In times of recession, large capitalised companies tend to perform better than small companies. Therefore, multi-nationals issuing corporate debt are likely to be as secure as national government debt and, in our view, should still represent good value and therefore should be a reasonable proportion of your capital invested in high grade corporate debt. There is likely to be a place for some derivative trading and the opportunity to make money as a consequence of the collapse in economic activity suggests that we should also have some exposure to selected absolute return funds. 

Cash could be a problem. It is very difficult to know which bank may get into trouble. Headline rates suggesting that banks are increasing depositors rates at this time is a great worry as it means that they may not be able to raise money in the wholesale market and therefore, are shifting the risk to domestic customers who think that holding cash on deposit is a safe and secure investment. Remember that there is no such thing as a safe bank, be it Barings Bank, Northern Rock or anybody else and remember the old adage that if they are paying more than the normal, the chances are they could be taking on a greater risk.

We have selected AIG as an excellent cash management facility for many of our clients but unfortunately, the minimum holding is £100,000.  Below this level, Fidelity offer a very attractive cash management facility as do Skandia, but for day-to-day banking requirements, remember not to have more than £35,000 in cash in any one bank deposit account (in any one name) at a time.

We suggest that we work towards rebalancing your investment portfolio such that 60% of your capital will be invested in gilts, fixed interest funds, corporate bonds and absolute return funds with only approximately 40% invested in a relatively defensive balance of equities. 

If you think an even more reduced exposure to risk in these turbulent times is appropriate for you, we will be quite happy to recommend moving a much greater proportion of your portfolio into fixed interest funds.

In a way we feel that it is a heads you win, tails you cannot lose scenario – although, of course, there are never any guarantees. In other words, there seems little prospect for equity markets moving ahead, and there seems little prospect for interest rates growing. There seems a high probability that equity markets may fall, and a high probability that interest rates may fall. There is also a high probability of inflation in the system.  If the market does not collapse, then you should not lose by adopting our investment strategy.  If the market does collapse, you will be incredibly pleased by following our advice. If we can get through the summer of next year and then see some clear signs that the liquidity crisis is coming to an end, then of course it is likely that we will recommend that you switch back into equities and other investment opportunities which may make significant gains. Remember that we started recommending that you invest in equities ahead of the market rally in 2003 much to everybody's extreme pleasure and subsequent huge gains. 

Tax

You should never let the tax tail wag the dog. If, as a consequence of our actions, we create tax liabilities for you, this will be because you have generated huge profits. Whilst we would like to minimise the effects of taxation, you should be aware that if markets correct significantly, the loss to your wealth is likely to be much, much greater than the tax effect of rebalancing your portfolio at this time. Where your investments are held in bonds such as Skandia or PEPs and ISAs, clearly you can switch money without incurring any tax consequence although there may be a charge for effecting the switch. I regret that at this time we will not be in a position to calculate your individual tax effect and you will have to accept that if there is a tax event, (which we will calculate after the financial year-end), then you will need to reserve funds within your portfolio to pay this tax bill in 2009.

Action

Speed is of the essence. Please will you return the rebalancing instructions as soon as possible if you believe that our suggestions are in line with your wish, caution and security. You are of course entirely at liberty to ignore our warnings. We clearly do not have a crystal ball and maybe completely incorrect. In general, our investment strategies to date have worked very well, we think they will work well in the future and the current action is simply to preserve your wealth in the short-term as we genuinely believe that the liquidity crisis should be over within 18 months.

The possibility of selling whilst markets are strong and then possibly buying into markets when they are weak in 18 months time could dramatically improve your wealth, financial security and performance in the years to come.