Observing a Crisis

The incredible volatility in the financial markets has eclipsed virtually everything else, including the US presidential race, the start of Major League Baseball playoffs to the underlying economy.

So far, study by The Boston Consulting Group (BCG) shows that the banking industry globally has lost more than a fifth of its value in the first half of 2008. Following on the declines in value in the second half of 2007, nearly all gains in market capitalization since 2005 have been wiped out.

In the first half of 2008, 13 out of 14 industry sectors worldwide experienced double digit falls in total shareholder return (TSR). According to BCG, in four industries – telecommunications, chemical, engineering and electricity – average TSR plunged by more than 40 percentage points in the first half of the year.

Consumer loan is general and credit card loans in particular, are now subject to much close scrutiny. It is clear that tightening lending standards are no longer a phenomenon exclusively linked to property loans.

It is the interaction of falling asset prices, a weakening capital base amongst financial institutions and high inflation that is putting not just the United States, but the entire world in dealing with a near perfect storm that it is also here that we will find the answers to our questions.

• As it started with housing, it will end with housing. House prices in the US, UK and some EU countries are still well above their long-term average relative to disposable income, I think there are considerable rooms for it to fall for quite some time, until prices are adjusted below their long term equilibrium values and the current overhang must be dramatically reduced. It may take at least two years, not months.

• Central banks – a pain killer, not a problem solver. It is important to have confidence in central banking, but they are not GOD. They make policy mistakes too, and likely to be repeated. A number of US banks have capitulated over the past year, and more institutions, including non-banking financial institutions are in pretty serious trouble at the moment. What do the central banks do is basically spending tax-payers’ money to fix something which is unfixable, not at all dissimilar to the policy mistakes made in Japan 10-15 years ago.

• The de-leveraging just began. While I am a commodity bull, there is no way that fundamental factors alone can explain the rise in oil prices that we have experienced in 2007 and early part of 2008. It seems that commodity prices may have to adjust little downward from current level before the fundamental equilibrium price is reached.

The bad news is that the end of the crisis looks further away as policy makers are still behind the curve as well as the limitations for the authorities to cut rates aggressively, as the real short term interest rates are currently still negative in 20 of the 36 countries in Morgan Stantley’s research universe.

The good news is the first stage of the credit crunch is now over. Forced liquidations are no longer a daily occurrence, hence some sort of normality is likely to return to global markets, but it remains uncertain the extent of damages that have been inflicted on the real economy.