Staying ahead in the credit crunch

By Stephen van Eyk

THE 2008 calendar year was obviously dominated by the continuation of the credit crunch that began in 2007, and the rapidly deteriorating outlook for world economics and stock markets.

Although we at van Eyk predicted conditions to be far worse than the industry expected (we stated in one edition of Money Management that we thought the industry was “screwed” in relation to the markets), the extraordinary market falls in October in reaction to rapidly deteriorating world economic conditions were quite another thing; reality overtook everything.

Our continued negativity towards market prospects was mainly based on the view that a turnaround wasn’t possible until the financial system showed signs of improvement.

One signal to look for is evidence that US banks are trading the yield curve by borrowing short, and buying long-term treasuries (US Government bonds).

This then leads to a situation where the profits from trading activities outweigh the continued writedowns from bad loans, and so bank share prices eventually rise.

Until the latest government interventions, none of this was happening.

However, the first tentative signs of a functioning financial system are now in evidence, and bank share prices are stabilising relative to the market. A reduction in the gap between the rate on quality commercial paper and the government bond rate would be another positive confirmation in 2009 should it occur.

An even more difficult challenge for investment research houses than picking the overall market direction was staying ahead of what products were going to be most adversely affected by the credit crunch and market downturn.

The most highly geared products investing in illiquid asset classes were immediately affected, with Centro very highly geared, the standout in a listed property trust sector where 30 to 40 per cent gearing levels are the norm for major trusts.

Loan covenants will determine the haves (adequate capital) and have-nots in the sector, with outstanding opportunities developing in 2009 as forced sales deliver cheap assets to fund managers with capital, and some further failures from those without capital.

Hybrid property funds froze in August 2008 as the disparity in valuations between listed and unlisted became apparent to investors, leading to redemptions.

The continuing fall in equity markets around the world, combined with a dramatic economic slowdown, has put the pressure squarely on products where more illiquid assets have not been adequately revalued downwards as yet, such as private equity, property, infrastructure, and so on.

This is particularly evident when portfolios are combined with listed assets that have fallen 50 per cent in value, thereby leaving unlisted assets breaching fund benchmarks. Unless listed markets rise appreciably, the forced sale of illiquid assets into an unfriendly environment could cause substantial valuation declines in many portfolios next year.

The Federal Government’s guarantee of banking deposits in September 2008 had the unintended consequence of leading to heavy redemptions in anything that was not guaranteed, with mortgage funds the unfortunate sector to bear the brunt of this market distortion.

Ironically, there are not many times in the cycle that mortgage funds are able to outperform cash after fees, but the current falling interest rate environment is one of them. So clients with their funds frozen in quality (highly rated) mortgage trusts should at least earn a sound return.

Fund of fund hedge funds, which performed remarkably well in the early stages of the market downturn, are now starting to exhibit the effects of the underperformance of some of their underlying strategies, the extra cost of leverage, and the layers of fees. Although sound opportunities will appear in some strategies next year, performance from the sector should remain sluggish and an underweight position is justified.

We remained concerned about particular underlying hedge funds facing difficulties due to the very high market volatility and redemptions. Well-diversified fund of hedge funds conducting intensified due diligence should be able to mitigate this risk.

Another test for fund managers has been the very high volatility in the Australian dollar, which plunged 38 per cent from a peak of US$0.98 on July 15, 2008, to a low of US$0.606 on October 27, 2008.

This reflected a significant downward readjustment to commodity prices and interest rate expectations on the back of the slowing world and local economies as well as de-leveraging out of high yield currencies by speculators and Japanese investors (that is, carry trade unwinding). This volatility had an impact on the short-term returns of funds invested in overseas assets.

After enjoying stellar returns during the past five years, Australian equities came down to earth in a manner not seen since 1987.

Investment research continues to uncover quality fund managers across a wide range of styles and discipline: large cap, small cap, ESG (environmental social governance) and extension (long/ short).

The latter category may have been adversely affected by the ban on short selling of financial and non-financial stocks. This situation has only been partially resolved and the sub-sector is requiring close monitoring but ultimately we believe it is an important option for investors.

Overall, 2009 should be a year of increasing opportunities.

However, the most important aspects of investment research will remain what they have always been — that is, ongoing monitoring of recommendations and their risk in relation to the market, portfolio strategy, and the appropriateness of the portfolios’ underlying benchmark.

Stephen van Eyk is the managing director of van Eyk Research.