Investment Update – Market Volatility

It has been a stressful month for global share markets with almost unprecedented volatility shaking share markets across the globe. After a difficult year, where all growth asset classes produced negative returns, it is clear that uncertainty in world markets has increased. Markets do not react well to uncertainty. While many market participants previously believed the worst of the “Global Credit Crisis” was behind us, September proved this wasn’t the case.

The key events that consumed the media and global share markets in September were the US Government’s financial rescue of AIG, the collapse and bankruptcy of Lehman Brothers and the takeover of Merrill Lynch by the Bank of America. This has all been happening with a backdrop of rising inflation and slowing economic growth globally, which is heightening the uncertainty in the market. It seems like every day there is new information and differing opinions causing large swings in financial markets and the need for government and regulator intervention has emerged. Uncertainty over the development of many of the current and proposed government initiatives to deal with current financial market difficulties should see this volatility continue in the market for some time to come.

The US government’s proposed rescue package was declined by the US House of Representatives on Monday 30 September, sending Wall Street into a panic and driving the Dow Jones Industrial Average down 6.98%, wiping a record $US1.2 trillion in value off the US sharemarket. The Australian share market quickly followed suit. Finally, the act was passed on 3 October 2008.

It is particularly important when we are faced with such difficult conditions, to remember that markets have always moved in cycles. While it is not possible for anyone to accurately predict the timing of the top and bottom of market cycles, many fund managers and market participants currently believe that very strong value propositions are emerging, despite the current trading and economic environment.

This market update discusses what has happened in the market, what is being done about it and what we can do as investors to navigate these uncertain times.

The Sub Prime Mortgage or Global Credit Crisis

To understand why the market has been so heavily impacted by the key events of September and October, it is important to consider how it all started. The subprime mortgage crisis is a current and ongoing economic problem which began during 2007 and 2008 that is marked by a lack of liquidity (or supply) in global credit markets and the banking system. The crisis has passed through various stages and has exposed several weaknesses in the global financial system and its regulatory framework. It is the result of a period of excessive individual and corporate debt levels (particularly in the US), risky lending and borrowing practices followed by a sharp downturn in the US housing market.

The crisis began with the bursting of the United States housing bubble causing high default rates on "subprime" and variable rate mortgages, beginning around late 2005. For many years prior, increased loan incentives such as easy initial terms and a long-term trend of rising housing prices encouraged borrowers to assume difficult mortgages, while believing they could quickly refinance on more favourable terms. Once housing prices fell, refinancing became extremely difficult. The easy initial terms passed, and vast numbers of people became unable to service their mortgage repayments; mortgage defaults and foreclosures increased dramatically.

The lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. This resulted in the collapse and subsequent rescue package by the US Government of Fannie Mae and Freddie Mac, the largest mortgage lenders in the US.

To make matters worse, a form of financial engineering called “securitisation” allowed these mortgages to be bundled into complicated financial instruments called Collateralised Debt Obligations (CDO) and Mortgage-Backed Securities (MBS) and sold on to third party financial institutions. The new owners of the instruments then assumed this significant credit risk, the value of these financial instruments fell dramatically and these companies had to record these losses on their balance sheets.

Around the world, as at 17 July 2008, major banks and other financial institutions had reported losses of approximately US$435 billion, which has resulted in various corporate collapses and rescues. With all this risk spread throughout the financial and banking sectors, companies have become unwilling to lend to one another resulting in difficulties in obtaining debt funding, higher interest rates and slowing economic growth.

A Big Month for Financial Markets

September proved a very significant month as the global credit crisis runs its course. It has now seen the collapse of two financial services giants on Wall Street. The first being Bear Stearns in March, then Lehman Brothers in September. The key difference between these events was that the US Government provided a takeover bid to rescue Bear Stearns, whereas Lehman Brothers was allowed to fail. Lehman Brothers filed for bankruptcy protection due to its holding of US$60 billion in distressed mortgage back securities after failing to find a buyer. This caused panic in financial markets globally. Potentially facing a similar fate, Merrill Lynch agreed to a takeover by Bank of America. AIG was facing a credit rating downgrade, following a significant fall in its share price, and put together a survival plan that included selling some of its most valuable assets, raising capital and going to the US Government for help.

In a bid to restore confidence in global financial markets, the US Government came to AIG’s aid, and has temporarily taken control of America’s largest insurance company. The Federal Reserve (Fed) has extended a US$85 billion two year loan to AIG in exchange for warrants representing a 79.9% ownership stake. This was done due to the belief that AIG’s business was too big and too wide-ranging to be allowed to fail. AIG insures over $450 billion in credit default swaps (CDS), held by financial institutions around the world. An AIG failure would trigger defaults on CDS terms, which could have been catastrophic for global financial markets. In addition, AIG debt is owned by millions of individuals through money market funds and the insurer covers so much of the US insurance market, so American consumers would have been very adversely impacted by an AIG demise, placing further strains on global economic growth.

Wall Street and the United States are not alone in their struggles. In the United Kingdom, UK bank Lloyds TSB bought rival HBOS following a dramatic fall in the HBOS share price. The British mortgage lender Bradford & Bingley is on the brink of collapse. In Australia, bank share prices have also suffered. Some high profile organisations have experienced massive depreciations in share prices due to the belief that their models are similar to US investment banks and they may suffer the same fate as their US counterparts. Despite this negative sentiment, the Australian financial sector has been surviving the global crisis extremely well. The Australian financial sector has very low levels of debt and exposure to distressed mortgage backed securities relative to the US and the United Kingdom.

Regulatory and Government Intervention

1. Ban on Short Selling

Government and Market Regulators globally have stepped in to assist financial markets. The first measure was a ban on short selling. Short selling is a practice used by some market participants and Hedge Funds in particular, where shares that the seller does not own are sold on the market with the intention to purchase them back at a lower price, allowing profits to be made in a falling market. While this practice can often provide liquidity in the market, it was viewed that in the current environment this practice has been placing too much downward pressure on share prices.

Friday, September 19: The Securities and Exchange Commission implemented a two-week ban on short selling in 799 financial companies, "to protect the integrity and quality of the securities market and strengthen investor confidence," according to a statement from the SEC.

The UK Financial Services Authority imposed a temporary ban, which took effect on Thursday September 18, on short-selling financial stocks. They stated the measure was needed to prevent further instability in the financial sector.

The Australian Securities and Investments Commission (ASIC) followed suit, placing a ban on short selling all shares on the ASX. This was designed to reduce volatility and to ensure Hedge Funds were not drawn to the Australian market after the bans were put in place overseas.

2. The US Government’s Rescue Package

On Sunday, 28 September 2008, the US Government made a breakthrough in talks to approve an unprecedented $US700 billion (AUD$840 billion) rescue plan to revive credit markets.

After an initial failed attempt to pass legislation to provide a rescue package to the US financial sector on 29 September, the US government enacted the Emergency Economic Stabilization Act of 2008. The act passed on 3 October 2008. The US Government has established a US$700 billion dollar Treasury fund to provide liquidity and restore confidence in the US banking system. The law which created the fund gives the Treasury US$250 billion immediately, then requires the President to certify that an additional $100 billion in funds are needed, and finally $350 billion are subject to Congressional approval.

The purpose of the funds are to buy residential and commercial mortgage loans, credit card securitisations, auto loans and other financial assets for which currently have a non-existent market. Companies that sell their bad assets to the government must provide warrants, allowing taxpayers to benefit from future growth of these companies. The President will submit a law to cover taxpayer losses on the fund, using "a small, broad-based fee on all financial institutions”. To participate in the bailout program certain tax benefits will be lost by these companies and in some cases they must limit executive pay. The bill also places limitations on golden handshakes and requires unearned bonuses to be returned. The fund includes an Oversight Board so the U.S. Treasury cannot act in an arbitrary manner. There is also an inspector general to protect against abuse, waste and potential fraud.

The rescue plan for US financial stocks is seen to provide a huge amount of support to global financial markets but the extent of the existing damage will take time to recover. The US$700 billion bailout intended to reassure markets that help was on the way, however, the value of the struggling US mortgage market is US$11 trillion. At the time of writing, a similar rescue package is being developed in by the British Government for the UK banking sector.

3. Global Interest Rate Reductions

The next step in promoting improved global economic growth was a round of interest rate reductions. In this effort, the RBA in Australia led the way, stunning the market by announcing a 1% reduction in the official cash rate to 6% on 7 October. The following day, U.S. Federal Reserve, European Central Bank and the Bank of England all reduced their official rates by 0.5%. Sweden and Canada followed suit while China cut its interest rates for the second time in three weeks.

What to do in times like these?

No one is alone is feeling nervous about such uncertain financial markets, but during these times is more important than ever to return to the basic rules of investment.

1. Remember, historically, the long-term trend is up

Over the last two decades there have been several major events that have had a massive effect on the Australian share market. These include the Wall Street Crash in 1987, the bursting of the technology bubble in 2000 and the September 11 terrorist attack in 2001. While each of these events resulted in a sustained period of market downturn, the market has always recovered. Additionally, when the market recovers, it has historically recovered strongly.

Short-term volatility and changing investment market cycles have always been a part of share market investment, but it is important to remember that the historical long term trend is upward. Australian shares, for example, continue to perform very well, up 197% in the last ten years. Similarly, Australian listed property, which fell nearly 38% this year, has returned 128% over the same ten year period.

2. Maintain and review your existing strategy

During times of uncertainty, it is important to refocus on the plan you have in place, what you are trying to achieve and how long you’re prepared to invest for. Keep in mind that the longer your investment timeframe, the more likely you’ll experience some form of short-term market volatility.

You also need to consider the level of risk you are prepared to take to generate returns and whether your existing plan still accurately reflects this. For example, high exposure to growth assets like shares and property can increase your long-term returns, but it’s likely you’ll experience greater short-term fluctuations than more conservative assets like cash.

3. Don’t overreact to short-term movements

Investment markets move in cycles, but no one can accurately forecast when they’ll rise or fall. Moving money in and out of the market during a downturn or during periods of heightened volatility means you can potentially miss out on any positive gains in a strong market recovery.

This view is supported by history. For instance, research on the Australian market since 1985 shows that the Australian share market returned an average of 28% in the year following a negative return.

4. Diversify your investments

Diversification involves spreading the risk associated with any individual investment by investing a variety of different investments and investments classes. Your Count Adviser can assist you in diversifying your investment across a variety of asset classes, regions, investment managers and investment styles.

Count Financial Limited adheres to a rigorous research process to ensure only the best rated investment products available are considered for your portfolio. Count has recently conducted a review of the direct exposures to Lehman Brothers, AIG and Merrill Lynch of the recommended international managers on Count’s Approved Product List. The result was one manager having a holding of slightly above 1% in AIG. All other managers were found to have less than 1% exposure to any of these companies.

5. Get professional advice tailored to your situation

As a client of a Count Financial Adviser, you are well positioned to obtain ongoing professional advice. Your Count Adviser can help you make informed investment decisions based on your needs, objectives and personal circumstances, while taking into account the current market environment. If you have any concerns in relation to current markets and how they are affecting your situation, schedule an appointment with your Adviser as soon as possible.

Cliff Dawson and Vicki Adams of Saward Dawson Financial Services are Authorised Representatives of Count. ‘Count’ and Count Wealth Accountants® are the trading names of Count Financial Limited, ABN 19 001 974 625. AFS Licence Number 227232. Principal Member of the Financial Planning Association of Australia Limited.
General advice warning: The advice provided is general advice only as, in preparing it we did not take into account your investment objectives, financial situation or particular needs. Before making an investment decision on the basis of this advice, you should consider how appropriate the advice is to your particular investment needs, and objectives.
 

Published : 8 October 2008