Market update – investing through the current crisis

The financial crisis

Throughout September and early October the global ‘credit crisis’ continued to escalate. Firstly, a number of major US financial institutions exposed to increasingly illiquid assets with rapidly declining values came face to face with the prospect of insolvency. After the failure of major investment bank Lehman Brothers and the technical insolvency of Fannie Mae and Freddie Mac, the US authorties stepped in to support global insurance group AIG and encourage a series of bank mergers to improve their capital bases.

The US authorities developed a US$700 billion rescue package to improve banking system liquidity, where the US Government planned to buy the toxic mortgage assets that had hampered global banking balance sheets. By the time the bailout bill had passed, after initially being rejected by the US Congress, the epidemic of fear had already crossed the Atlantic, with the solvency of major British and European financial insitutions increasingly under question. As such, the UK government and the Bank of England and the European Central Bank also had to make a number of interventions to save troubled banks.

The result was an almost total freeze of global credit markets, with banks afraid to lend to each other, let alone to households and corporations.

Sharemarkets experienced a series of dramatic plunges culminating in near panic selling on Friday 10 October. The ‘credit crisis’ had become a crisis of confidence in the solvency of finanical institutions worldwide and encompassed all investors in all regions.

Realising the situation was increasingly dangerous the UK and other European governments announced a series of direct capital injections for major banks, pumped funds into the short-term credit markets as fast as they could, and announced Government guarantees for bank depsits. The US shortly afterwards followed suit.

This coordinated effort seemed to avert the worst crisis of confidence in the financial system in our lifetimes. The result is that some of the biggest financial institutions in the world are now partly or wholly owned by governments, restoring some level of confidence in the financial system. It will still take some time for credit markets to be restored to some level of stability, and it is clear that in the years ahead greater regulatory control, higher risk premiums and tighter lending standards are highly likely. 

While the major Australian financial insitutions had escaped relatively unscathed from solvency concerns, the Australian Government announced further injections of funds into credit markets and its own guarantee of bank deposits. The Australian financial system is much more tightly regulated than overseas and lending practices are conservative.
The stress in the US financial system has led to tighter financial conditions around the world. Many of the advanced economies such as the US, Europe, the UK, Japan and New Zealand are close to or are already in recession, while the growth in the emerging economies is also softening, but will continue to grow at a faster pace than their advanced peers. The International Monetary Fund recently forecasted that global economic growth would slow to 3% in 2009, which represents its slowest pace since 2002.                                                 Return to top

What is the outlook for Australia’s economy?

The immediate outlook for the domestic economy remains reasonable reflecting the continued national income effect from our coal and iron ore exports, the recent reductions in official interest rates, a $10.4 billion fiscal package and the recent decline in the Australian dollar, which should support our export sector.

Importantly, the Reserve Bank of Australia has significant room to further reduce official interest rates more and the Federal Government could further lower its fiscal surplus, to support growth if required. In mid-October the Federal Government stated that it could bring forward the tax cuts for the 2009/10 financial year if the economy weakened further. Meanwhile, the Future Fund and the ‘no net-debt’ position of the Commonwealth Treasury indicate that ample capital is available to support the banking system in the short-term and fund infrastructure development over the medium term.                                                         Return to top

How have sharemarkets reacted?

Global sharemarkets
The focus of investors has shifted to the economic flow-on effects from the financial crisis and increasing likelihood of recessions in the advanced economies and a slowdown in the developing economies such as China and India. Such a slowdown would negatively impact corporate earnings growth and share prices.

Despite the large-scale actions by the global monetary authorities, global sharemarkets have experienced wild daily swings reflecting the heightened level of uncertainty that remains. Clearly, it will take time for confidence to return to global capital markets.

The Australian sharemarket
By mid-October 2008, the Australian sharemarket had declined by around 42% since its 1 November 2007 peak, making this current downturn the fourth worst in Australian sharemarket history, with prices down to levels last experienced in November 2004. However, patient investors know that the Australian sharemarket has always recovered from these once-in-a-generation events such as the Great Depression, the 1973 oil shock and the 1987 sharemarket crash.

Looking ahead, the Australian sharemarket is likely to remain volatile in the near term, reflecting considerable uncertainty about the global economy. Corporate Australia has clearly entered a more difficult trading environment for 2009 so earnings growth will slow in line with the softer domestic and global economies and profit margins will be squeezed. The new environment will mean stocks with weak balance sheets will struggle and will need to reduce their amount of debt by either shrinking their balance sheet or raising additional equity.  In addition, stocks with opaque business models will struggle as investors look for earnings certainty and stocks which have previously performed well in tough economic times.                                                                          Return to top

Quality can provide protection

Markets are now valuing balance sheet strength and earnings certainty more than anything else. Given the heightened level of uncertainty, it is hard to predict what markets will do from here. What we can say is that those companies with high cash and low debt, sustainable business models and sustainable cashflows are likely to be viewed favourably by risk-weary investors in the period ahead. These companies will be able to fund their growth, be less reliant on external funding sources and be in a strong position to purchase assets which are at distressed prices.

Investors should be mindful that it may take considerable time for financial conditions to return to what would be perceived as being ‘normal levels’. We are also likely to see increased regulation and more stringent capital and risk controls and as such it’s difficult to recall a time in history when balance sheet strength and cash flow has ever been as important to both corporations and their stockholders.

At this point in time these factors are the key determinants of each stock’s investment performance but once the storm passes, these same companies will be in a good position to grow their businesses organically. Given the uncertainty in the global financial markets a re-rating of these high quality companies appears likely as they are best placed to outperform in the new environment. What we are seeing is the changing of the guard away from the complex financial-engineered strategies which were favourably viewed in the four years to July 2007 back to the traditional, fundamental approach, which has outperformed over the long run.                           Return to top