IZOLO –Thursday 11th August 2011

  So just what has happened over the last number of days where we have seen our All Share Index plummet from 32065 on the 25/07/2011 down to 28391 on the 08/08/2011 – a drop of -11.46% - and then show an almost overnight rise to 29490 on the 11/08/2011 – and increase of 3.87%

And then we have seen the US S&P500 drop -4.42% (in US$ terms this is a HUGE drop) on Wednesday only to rise by + 4.63% (again in US$ terms this is a HUGE gain) on Thursday – the very next day!

Similarly, we saw the VIX (better known as the world fear index (fear of a global financial meltdown) move from 19.87 on 12/07/2011 (the top end of the “normal” range) all the way up to a peak of 48 (meaning that the money men saw a close on 50/50 chance of a total global meltdown happening) on 08/08/2011 but which has now moved down to 43 on the 10/11/2011. High, yes, but starting to move in the “right” direction – being downward.

Finally, we saw US 10 year treasury bonds yields (people buy US 10 year treasury bonds aggressively when their fear of a global economic meltdown happening rises – which drives yields down) move down from 2.9% on 12/07/2011 to 2.1% on 10/08/2011 – again in US$ terms a HUGE difference – indicating a massive flow of funds (thus risk aversion) into 10 year treasury bonds – and then to watch these yields moving out again – indicating people are starting to feel a little less risk averse to 2.3% on 11/08/2011 – again one day later.

SO just what IS happening? Or what DID happen. Or, to ask the most important question of all from an investment point of view, what is GOING to happen? Is this overnight recovery the start of a whole new bull run and should we be jumping back into the market, or is this just a false summer?

Having thought on this issue long and hard this is how I explain to myself what has just happened.

It starts with two expected (and well known in advance) events. Firstly, the US Government and the US Federal Reserve Bank stimulus packages coming to an end around 30^th June of this year. Between 2008 and end June 2011, the US Government and the US Federal Reserve pumped around US$6 trillion into the US economy in an attempt to prevent the US economy going into a double dip recession (which would have negative ripple effects globally) and to create new jobs for its electorate following on from the jobs lost as a result of the crash of 2008.

The world know this was going to happen but kind of said to itself, “well, if it turns out that further stimuli is needed after good old “uncle Sam” will just continue to throw money at the problem up until it ultimately goes away, so let us carry on investing regardless.

However July came and went and no further stimuli were announced, either by the US Government or by the Federal Reserve, despite the fact that things were not looking quite as rosy as they used to, forgetting for a moment about the problems in Europe. So a small self-off started, “just to be safe”. Nothing big. Just a normal gradual downward movement in stock prices to provide against the possibility that the economic recovery (unaided) and thus corporate profits, might take a bit of a knock before coming back as they always do – even unaided.

However, at almost this exact same time, a number of converging events occurred, the outcomes of which were all unpredictable as all of them were without precedent, these events being:-

 

1. The agreement needed to raise the US Debt ceiling went right down to the wire, to the point that it was not certain that it would in fact be raised at all. Had the debt ceiling not been raised, this might have resulted in the US defaulting on its debt, which in turn would have caused what can only best be described as global financial Armageddon. In fact, the agreement to raise the debt ceiling by US$2.1 trillion was only reached by the US House of Representatives on the 1^st August ONE DAY before the deadline date, and was yet to be ratified the following day by Congress on the actual deadline date 2^nd August.

            As this has and had NEVER happened before, there was thus no way of preparing for what might have happened had the US defaulted             on its debt. This issue has now however been taken off the table for the time being, so the immediate threat has passed, but the                        agreement to raise the debt ceiling also came at a huge price, that being to cut future US Government debt by US$2.4 trillion or more                over the next ten years, this WITHOUT raising taxes. (More on this later)

 

2. Next, as a result of the negotiations around raising the debt ceiling going right down to the wire, it become evident to all concerned that there is a great deal more contention in the US surrounding its debt problems than was initially thought to be, as well as a greater divergence of opinion between bitter political rivals on how this issue of the reduction of the current level of US debt is to be addressed going forward.

 It is for this reason (and not for reasons of inability to meet their debt obligations, which the US can easily do) that the ratings agency Standard and Poor took the unprecedented step of downgrading US Government debt from AAA to AA+ with a negative outlook.

 This downgrade is not something insignificant, as the US has for as long as can be remembered NEVER had a rating of less than AAA and thus US Government Bonds were used as the world’s “benchmark” in so far as establishing the rate to be paid on alternately rated debt was concerned.

 Thus in the past, if the rate on 10 year US Government Bonds was (say) 3%, and a government with a AA rating wanted to raise a loan in the international markets, then they would pay the 3% (the so called “risk free” rate determined by the US) plus the additional risk premium that a AA rating would command (say 2%). Thus this AA rated government would pay 5% (3% + 2%) on any loans raised in the international markets at that time.

 Note also that banks, insurance companies, pension funds and the like globally are perpetual buyers of government debt (bonds) thus the interests rates that they pay and charge also link back to these “risk free” US rates.

 So when the US Government Bond was no longer considered to be “risk free” (based on both a possible default along with an actual downgrading to AA+) the world lost its historical benchmark overnight – but had no viable alternative to turn to, either existing or emerging, to replace it, so no one quite knew what to do for a short while other than to enter into a state of panic, utter confusion and bewilderment.

 As things now stand, it seems to have dawned upon everyone that given that there is actually no viable alternative to US Government Bonds, almost no matter what happens, it has no other option than to return to doing things the way that they were always done in the past, despite the fact that things they are no longer quite the way that they always were.

  

3. The third thing that happened was that had the US defaulted on its debt, the value of the US$ would have gone into a virtual downward death spiral – something similar to what happened to the Zim Dollar (but not quite as bad).

 This thought obviously did not sit well in the minds of the global investing community, especially with those investors sitting on trillions of US$. This is because up until then, the US$ has always been seen to be the “currency of last resort”. That is to say, it was seen to be virtually indestructible in that if all of the rest of the world’s currencies failed, it would be the proverbial “last man standing”.

 This is why in times of global financial crises you will always see a massive strengthening of the US$ relative to most of the other international currencies (including our humble South African Rand) as investors around the world take cover in the US$ by withdrawing from whatever other currency they might be invested in at the time to convert their investment back into US$.

A further contributing factor to creating doubt over the future strength of the US$ was the printing of trillions of US$ by the Federal Reserve, the now well-known QE1 and QE2 programs.

 This uncertainty regarding the future of the strength of the US$ led directly to the flight into gold as the FINAL currency of last resort – thus explaining the huge run up in the gold price.

 However, the world has also once again since discovered that there is no viable alternative to the US$ and neither will there be one anywhere in the near future, so it is not so much a return of confidence in the US or the US$ that is returning, but a sense of the fact that given the lack of alternatives, one has no real other option open to them but to go back to “trusting” in the fact that the US will somehow muddle through its problems and that the US$ will hold its value of the short, medium and longer term.

 

4. The final player in the recent drama was Europe in that although everyone was aware that they were struggling with their own debt issues, (Ireland, Greece and Portugal primarily) almost out of the blue Spain and Italy started to enter the picture as possible problem children, and if these two countries did (do) in fact become problem children, one could almost them imagine the death of the euro as a currency as there just is not enough space in the lifeboat to carry these two countries if their ships sink as well. As I write this, the scramble to paint Spain and Italy out of the “debt problem” picture continues and has yet to be resolved.

 It is thus my view that it was the combination of the above four factors that caused the MASSIVE short term market selloff at the beginning of this month, but as points 1,2 & 3 were “resolved” in the minds of the investing community, there has been an equally aggressive “buy back” into the market.

In short, now that this bout of short term uncertainty has passed and the markets have moved back to their “pre-crises” levels, we find ourselves once again having to return to the basics and take a long hard look at global economic fundamentals, how they are going to play out going forward into the next number of years, and what this means in terms of returns to be expected from the markets.

 Hope you enjoyed the read. Back with more later.