Policies need time to ease credit market

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Global equity markets remain in the cellar, as frozen credit markets slowly thaw. There have been a few stellar days on the market, but they have barely made a dent in the losses incurred over the past year.

So far, the response to the credit crisis has included rate cuts, mortgage buybacks, coordinated takeovers and governments’ taking equity stakes in some of the world’s largest financial institutions. While these moves instantly made headlines, investors need to remember that they will take time to be implemented.

“I believe that most of the pieces are in place to get us out of the short-term credit crisis already,” says Suzann Pennington, senior portfolio manager, Saxon Financial. “I’m not sure I’d call this being out of the woods, but I think we’ve found the bread crumbs to follow to get ourselves out of the woods.”

Public policy moves have “put a floor under” the financial system, she says, and both the overnight and three-month inter-bank lending rates have eased.

While global banks may be lending again, the next problem to rear its head will likely be a slowdown in the overall economy. While a recovery plan is in place for the financial system, the markets are already looking to Main Street.

Investing at the Brink: How low is too low?

On October 16, Advisor.ca held a conference call with

Rory Flynn Senior portfolio manager AGF International Advisors	Nevin Markwart Senior vice-president and head of Canadian equities Fidelity Investments

Here’s what they had to say.

The past month and a half have been brutal for investors, with the major global indexes falling off a cliff, posting year-to-date losses in the neighbourhood of 40%. This has been despite several government interventions, including the $700 billion package that the Americans trotted out. Over the Canadian Thanksgiving weekend, European governments rolled out yet another plan, and the markets only rallied briefly.

What will it take to get out of the woods on this credit crisis?

Click here to listen to their responses. (Nevin, Rory)

Part of the U.K. rescue plan included the partial nationalization of three big banks. In return for the government intervention, these banks were required to stop paying dividends. How has the partial nationalization of banks in both the U.K. and the U.S. affected your investment strategies

Click here to listen to their responses. (Rory, Nevin)

The decline took about a month to reveal its full extent, and investors were repeatedly told “this is a great buying opportunity.” How do you know when you are falling into the “value trap” and buying stocks that are going to continue falling?

Click here to listen to their responses. (Nevin, Rory, Nevin)

What signs are you watching for that would signal either another downturn or sustainable growth? Is there another identifiable shoe to drop?

Click here to listen to their responses. (Rory, Nevin)

Advisor.ca would like to thank Rory and Nevin for taking time out of their busy schedules to share their insight.

“One of the most important [measures] for the real economy is the commercial paper funding facility that is going to provide a backstop for the needs of good quality non-financial companies,” she say. “That doesn’t really kick in until the end of this month.”

Among the more controversial elements of the global rescue plan has been the partial nationalization of some of the world’s biggest banks. The British government has taken an equity stake in three banks, a move that was followed by the U.S. government. Pennington says that Ottawa is unlikely to take such drastic action.

“The one injection of liquidity that has been provided to the Canadian banks, the $25 billion to buy insured mortgage pools, essentially provides them with reasonable cost capital in a market where the cost of capital has been the real issue for them,” she says. “I think that’s going to be fully sufficient for the Canadian banks, and you aren’t going to see direct investment in them by governments. It’s simply not necessary.

“The Canadian financial system is simply not in the crisis that some of the other banking systems are in,” Pennington continues. “We’re much better capitalized; we don’t have the same mortgage issues; we didn’t have the same extent of variable rate mortgages that caused the problem in the U.S.”

South of the border, homeowners are able to simply walk away from the mortgage without any personal liability. In Canada, the banks are much better protected and can garnish the mortgage-holder’s wages to recover their capital.

In the U.S., 20% of mortgages have negative home equity. If home values fall another 15%, there will be 40% with negative equity.

“All the measures to date have focused on averting financial crisis, but none of the measures have targeted directly the pressure on the U.S. housing market, which is at the heart of the problem to begin with,” she says.

Traditionally, homeowners struggling to make their mortgage payments were able to renegotiate the terms of the loan with their local bank. This flexibility was lost when mortgages started to be bundled together and sold on to investors. In many cases, Pennington says it is unclear who even holds the mortgage anymore.

Because the housing market is at the heart of the economic slowdown, she will be keeping an eye on the inventory of unsold homes as a cue to a market turnaround.

“As we get down to about six months of inventory, we’ll feel more confident that the worst is over in the housing market and we can drive forward,” she says.

Throughout the current downturn, there have been suggestions that investors get any money they have on the sidelines into the market to take advantage of discounted stocks. Pennington is not a fan of such advice.

“Somebody reminded me recently of a quote that says, ‘If you’re the only one keeping your cool while everyone else around you is panicking, perhaps you don’t understand the severity of the problem.’ I think that may have applied in this circumstance,” she says.

In her 20 years of managing money, she was never more concerned than when the credit markets froze up in mid-September, which made it impossible for her to quantify investment risks. Within 24 hours, the U.S. government started rolling out its first significant rescue package.

During that brief period, she says, anyone who was advising investors to buy on the dips simply didn’t recognize the severity of the issue.

Investing at the Brink: How low is too low?

On October 16, Advisor.ca held a conference call with

Rory Flynn Senior portfolio manager AGF International Advisors	Nevin Markwart Senior vice-president and head of Canadian equities Fidelity Investments

Here’s what they had to say.

The past month and a half have been brutal for investors, with the major global indexes falling off a cliff, posting year-to-date losses in the neighbourhood of 40%. This has been despite several government interventions, including the $700 billion package that the Americans trotted out. Over the Canadian Thanksgiving weekend, European governments rolled out yet another plan, and the markets only rallied briefly.

What will it take to get out of the woods on this credit crisis?

Click here to listen to their responses. (Nevin, Rory)

Part of the U.K. rescue plan included the partial nationalization of three big banks. In return for the government intervention, these banks were required to stop paying dividends. How has the partial nationalization of banks in both the U.K. and the U.S. affected your investment strategies

Click here to listen to their responses. (Rory, Nevin)

The decline took about a month to reveal its full extent, and investors were repeatedly told “this is a great buying opportunity.” How do you know when you are falling into the “value trap” and buying stocks that are going to continue falling?

Click here to listen to their responses. (Nevin, Rory, Nevin)

What signs are you watching for that would signal either another downturn or sustainable growth? Is there another identifiable shoe to drop?

Click here to listen to their responses. (Rory, Nevin)

Advisor.ca would like to thank Rory and Nevin for taking time out of their busy schedules to share their insight.

“That takes us to rule number one in avoiding value traps, and that is if a stock is statistically inexpensive, it’s usually cheap for a reason,” she says. “If you can’t figure out what that reason is and reasonably quantify the risks to that stock for that reason, then you should just stay away.

“Sometimes we simply don’t have enough information to evaluate the downside risk of a company. In those situations, there are lots of other companies that you can look at.”

She uses the example of a house that is underpriced because of a bad exterior paint job. This house can be repainted to boost the value. But if a perfectly good house is being undervalued because a nuclear power plant is about to be built across the road, that house’s value will be permanently impaired.

“Even in the bull markets I’m worried; value investors are by nature. On the risk side of the ledger, I’m worried consumer debt defaults are rising, credit card debt defaults are rising, but those are lagging indicators.”

On the positive side of that ledger, she says, rapidly emerging markets should still drive global growth forward. While China may be experiencing a slowdown of its own, it should see economic growth of about 8%.

The severity of this downturn has been particularly difficult to gauge, as analysts argue over whether it is cyclical or the start of a drawn-out, secular shift. Pennington is convinced it is actually both.

The impact on the financial system will mark a turning point in the way banks do business, making it a secular shift. It could also see American consumers return to saving some of their earnings, rather than racking up massive debt. This would be another secular change.

“From a cyclical perspective, we’ve seen a normal cyclical economic slowdown exacerbated by these other factors, so we have quite a severe global recession that we’re facing, but that is cyclical,” she says. “One other secular factor on the positive side will be the BRIC nations are still going to be drivers over the longer term, and we are going to see a secular change in what’s going to be driving the global economy over the next 10 years.”