The trends to watch in 2009

PORTFOLIO POINT: Investors should be looking beyond the day-to-day noise of the market at five factors likely to influence the year ahead.
It has been an unusual but very useful Christmas/New Year break. It started with the avalanche of forecasts from a series of nervous commentators who, like most people, had underestimated the severity of the 2008 global downturn.

For the most part it was very depressing news. Yet one survey stood out from the rest and proved to be a good guide for what would happen in Christmas trade.

The Roy Morgan Consumer Confidence Survey rose for five consecutive weeks in the leadup to Christmas and in the last few days of trading it was at its highest level since March 2008: In other words the combination of lower interest rates and the Rudd stimulus package plus lower prices worked and created a strong retail Christmas demand although margins were often down.

And so, consumer confidence, plus low prices, caused Australian car sales to rise in December when most people expected them to fall. Then the Chinese claimed that their 2009 growth rate would not be decimated in the way that many forecasted and predicted 8% growth for 2009 – good news for commodities and Australia.

As I moved among holidaying business people I discovered that in some areas there is a lot of activity. The stockmarket initially responded to all this, throwing off the pessimism of the end-of-year forecasters. But the weight of bad news and the underlying problems caused a correction. Nevertheless, the local market is up about 10% since a low point on November 20.

At this point I need to warn all Eureka Report subscribers that we are in uncharted global territory and anyone who claims to know exactly what is going to happen next is taking a big punt and more likely to be wrong than right. But what we can do? Our task here at Eureka Report is to keep watch on the important indicators. Therefore in this, my first column for 2009, I have isolated five major areas to watch. (The selection is mine but I was helped by the excellent HSBC Macro Global Economics report)

Those who have followed my writings over the years will be surprised to see the absence of the sharemarket among those indicators. I have been a great believer that the market would tell us what will happen in the future. In 2008 it was right once again. But just at the moment the sharemarket is either being battered by excessive pessimism, or floats on a cloud that is over-optimistic about the future. We need to follow other trends to help us determine whether it is giving the right indicator.

1. Deleveraging

The first of these trends is the deleveraging/asset value phenomenon. In the leadup to the crisis we saw almost unlimited credit available to businesses and consumers, which boosted asset values and borrowing levels. As a result of many well publicised events global credit has been substantially reduced. We are in a process of deleveraging or lessening the amount of borrowing that can be safely attached to assets. This is a massive world movement that will spread over some years.

The great danger in this process, particularly if it happens rapidly, is that it will substantially reduce the value of assets and, as it does that, further squeeze the amount of lending available for those assets. A vicious circle develops. We saw this happen in margin borrowing on shares but once that process spreads to dwellings and commercial property it can have a devastating effect on the total economy. Indeed, it leads to asset price deflation and people, in fear, hoard money rather than buy assets that are going to fall in value. We have already seen some of this taking place. These are among the forces that gripped the world in the Great Depression. I am not forecasting a depression but we will need to monitor this effect on asset values. But be careful of the process because some values have already fallen although the decline in value either has not yet been recognised or are just being recognised.

The 2008 asset value fall includes the sharp fall in the value of expensive dwellings and the decline in infrastructure and commercial property values that took place in 2008.

As a result, the huge Babcock & Brown write downs and the Macquarie Office capital raisings are all about the 2008 decline. During 2009 more asset price falls that relate to 2008 will become known and more capital will be raised and many will wrongly see them as 2009 declines. What we need to watch for is a further deterioration and we need to monitor the total global situation. For example, in 2009 one would hope that American houses would stabilise in value and perhaps edge higher from their lows.

2. Global capital flows

The second area to monitor is the availability of world capital flows. These are becoming more important than interest rates, which are close to zero in many markets. What is occurring in the US, for example, is that the governments are backing banks with equity but are tagging those equity injections with instructions to help the American housing and other domestic markets. That means less money to fund global banking. It could become a strange form of protection. This week’s big $3.5 billion NAB bond issue on the back of the Australian government guarantee was, in my view, the best news Australia received over the Christmas/New Year break.

If the trend set by NAB continues the effects of Australian credit squeeze will be reduced and be confined to tightening of lending criteria and the need to replace overseas bank lending in the local market. (Late Friday January 9 Bloomberg News reported Commonwealth Bank was carrying out a successful $3 billion bond offer while NAB was adding another $500 million to its existing offer).

Meanwhile, Treasurer Wayne Swan has been castigating the banks if they do not pass on in full Reserve Bank interest rate reductions. But, as Swan well knows, the banks’ costs also depend on overseas borrowing rates. What has been happening is that the business community has borne the full brunt of these higher costs and this will contribute to unemployment. If overseas borrowing costs fall (and the NAB issue was a good sign) Australian business will get relief while the whole overseas bank lending market remains close to dormant. Many enterprises, such as OZ Minerals, have had great difficulty in replacing overseas borrowings. So the flow of overseas funds to banks and the interest rates being charged business are going to be very important indicators in 2009.

3. The Obama factor

When US President-elect Barack Obama takes office on January 20 he plans to print US dollars on a massive scale. There is no way his expansionary plans can be funded by overseas lenders. There are a great many different forecasts as to what effect this is going to have on the US and the world.

The optimists say it will provide the stimulation the US economy badly needs. The pessimists say that it will trash the US dollar and eventually lead to inflation.

Of course similar, although not as ambitious, programs are being undertaken or considered around the globe.

I simply don’t feel qualified to forecast what is going to happen in the longer term but US currency values are in clear danger. For investors gold is returning to fashion. However if the Rudd measures are any guide, Obama will boost American consumer spending in the medium term. We will all need to watch the longer-term repercussions.

4. China

Some of the news that came out of China over the holiday break showed that country's economic decline was severe, which helps explain the extent of the fall in commodity prices. But the decline in commodity prices was, of course, multiplied by the exodus of the hedge funds from their big leveraged positions. China could disintegrate if it does not resume an 8% plus growth path so we have a huge stake in China's economic stimulus package being successful.

5. Danger points

Finally there are a series of weaknesses in the financial system that are being contained but may erupt. For example, the so-called synthetic CDOs [collateralised debt obligations] will result in an enormous transfer of capital if certain (in fact, just nine) American companies collapse; the overall weakness in the banking and derivative systems is sure to create crises from time to time; and we have the Middle East powder keg. In addition, most analysts are over estimating the likely level of profits so there is a lot of downgrading in stock to come both in Australia and around the world, with more companies facing up to the need to raise capital, which affects stock prices.

In looking at your portfolio, those that have undergone a capital reconstruction are safer than those that have big borrowings and have not reconstructed or recognised the need to cut asset values. So it goes.

As you look at this series of dangerous situations it is easy to resort to hoarding your money to ride it out. Many are doing this. But we should not forget that the world politicians have seen what the collapse of Lehman Brothers did to global economies and are determined to do what ever is required to avoid global carnage. In addition, whereas in 2008 the problems were unfolding now they are on the table for all to see and so are easier to manage.

Harvey Norman chairman Gerry Harvey is fully invested and believes he will win in the longer term but has been suffering pain. There are a great many Eureka Report subscribers who still have a strong cash position. During 2009 there is a clear chance that we will see the bottom of the market. We may already have seen it. Our strong companies represent unique value, which will come to the fore once the world can look back on the crisis.