MarketThoughts Special Alert: Policy Makers Need to Act Now
(September 30, 2008)
Dear Subscribers and Readers,
The House of Representatives "threw a curve ball" on investors yesterday, as the House voted 228 to 205 against the Troubled Assets Rescue Plan (TARP). This piece of unexpected news hit the Dow Industrials for more than 500 points in a matter of minutes. By the close on Monday, the Dow Industrials was down 6.98%, the Dow Transports 5.20%, the NASDAQ Composite 9.14%, and the S&P 500 8.79%. Weakness was broad-based, as all ten sectors of the S&P 500 declined. Not surprisingly, the S&P 500 Financials index was down the largest, declining 16.01%. The S&P 500 Energy Index was the second largest decliner, down 10.93%. The S&P 500 Consumer Staples and Utilities indexes, on the other hand, exhibited the most relative strength, declining only 4.21% and 4.90%, respectively. The S&P 500 Information Technology index - driven by an Apple Computer downgrade, was down 9.22%. This weakness carried into the technology-biased NASDAQ Composite Index, resulting in the index's largest decline since April 14, 2000 (when Stanley Druckenmiller was forced to dump Quantum's technology holdings onto the market because of margin calls), and prior to that, Black Monday, October 19, 1987.
As I mentioned in both our commentaries and in our discussion forum, the $700 billion TARP was and is still necessary to halt the current vicious cycle of selling and deleveraging in not only the US financial sector, but the global financial sector. This vicious cycle of deleveraging - which accelerated when Lehman was allowed to file for bankruptcy - engulfed Wachovia, Fortis, and Bradford & Bingley over the weekend. If Morgan Stanley and Goldman Sachs had not filed to become bank holding companies by last Thursday evening, chances were that at least one of them (i.e. Morgan Stanley) would also have filed for bankruptcy (or sold for a song) by Monday morning. With the latest equity injections (and significant confidence booster) into Goldman and Morgan by Warren Buffett and Mitsubishi UFJ, respectively, this issue is off the table, for now. However, if Congress does not pass the TARP soon, this could again snowball into an uncontrollable crisis. Already, news is coming in that Dexia SA, the (Belgian/French based) world's largest lender to local governments, was given a US$9.2 billion lifeline by the French and Belgian governments. This rescue will be in the form of an equity/convertible bond investment. While this will be dilutive for existing shareholders, it is interesting to see that neither the French nor the Belgian governments is doing this deal at severely punitive terms. With the majority of the US financial sector still being demonized, I doubt such a rescue resembling this will fly in the US anytime soon (Congress, however, did quietly pass a bill that will provide $25 billion in low-interest loans to our "Big 3" automakers).
Aside from more cash injections into the global banking system and money markets, neither the European Central Bank or the Bank of England have moved to slash interest rates thus far. With crude oil now trading below $100 a barrel, copper below $3 a pound, and with "second-round inflation" effects now quickly dissipating around Europe, it is now much more prudent for both the ECB and the BoE to cut rates as opposed to adopting a neutral policy - even though both central banks have a strict inflation-fighting mandate. Should the global financial markets remain strained going into the ECB's policy meeting on October 2nd, I would not be surprised if they decide to cut by at least 25 basis points during that meeting. On the contrary, I would be surprised if the ECB does not at least adopt an easing bias. As for US monetary policy, Fed Funds Futures are now discounting approximately 44 basis points of further easing by the end of this year.
The combination of the passage of the TARP and the possibility of a round of coordinated rate cuts by the ECB, BoE, and the Federal Reserve should serve as a significant confidence booster for the world's equity and credit markets. The People's Bank of China too, will need to continue to ease monetary policy, as the Chinese economy is now slowing dramatically on the heels of a significant weakness in real estate prices/construction and the general lack of credit availability. In my preferred scenario, policy rates at the ECB and the BoE should be at least 200 basis points lower, but for now, the market will just take any cut as a confidence booster. Whether any global equity rally will be sustainable will depend in large part on the policy actions from the ECB, the BoE, and the People's Bank of China going forward.
This too, shall pass. Valuations by many measures are now at their most attractive levels in at least 15 years. There is still an immense amount of cash sitting on the sidelines - in mutual funds (cash levels at equity mutual funds rose to 4.5% at the end of August, the highest level since November 2004), hedge funds (it is estimated that as much as 1/3 of all hedge fund assets is now in cash), sovereign wealth funds, and in corporate balance sheets across the world. The passage of the TARP will be an immediate confidence booster to the global markets - and will bring a significant chunk of this cash into the financial markets. Hopefully, the dramatic 777-point decline of the Dow Industrials yesterday was sufficient to change the minds of many House Republicans. If not, then this will go down as a policy blunder akin to the Smoot-Hawley Tariff Act of 1930.
Henry To, CFA