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Market Convulsions - John Redwood Comment

May 21, 2010

John Redwood Comment
21st May 2010

Market Convulsions

As we feared this is proving a difficult year for investors. We have long thought the best in world share markets was over. Last year's substantial gains heralded the recovery in world economies from the worst of the Credit Crunch. The dislocation that caused was always likely to extend a long shadow, and leave us vulnerable to aftershocks.

The main unfinished business from the Credit Crunch arose from the transfer of so many liabilities from the banks and the private sector to the governments. In Europe and in the USA governments plunged into extra borrowing as if they no longer had to obey the laws of economics. Underwriting or assuming banking liabilities was just part of a massive expansion of their spending at a time of constrained tax revenues. The private sector borrowing crisis gradually morphed into a public sector borrowing crisis.

Markets have been weak this month because liquidity has dried up again. In China, the authorities are trying to throttle back to curb incipient inflation and a rampant property market. This led us to take profits on our general commodity positions when oil was around $80 a barrel, as we thought commodity markets would show the first response to less Chinese buying for stock and less speculative cash. They have fallen sharply as we feared.

In Euroland things have gone from bad to worse.  The growing pressure of the bond markets on the countries with the largest deficits forced the authorities into the $1trillion emergency package of loans and guarantees. It was impressive, but markets want to know the underlying cause of the deficits is going to be tackled.

In the last couple of weeks Europe has been particularly weak because people are worried about the state of European banks. Many banks have bought large quantities of the bonds on offer from the high borrowing European governments. As those bonds fall in price so the banks find themselves in a weaker position, with large unrealised losses on their holdings. We have experienced a smaller re-run of the problems of autumn 2008, when banks distrusted banks and liquidity in markets vanished.

The last straw was the decision of Chancellor Merkel of Germany to impose a ban on short selling of bank shares and government bonds. Her words of worry about the state of the Euro and her actions implied the German authorities were concerned about something very serious.  Naturally this clumsy intervention led to the very instability she thought it might reduce.

We have advised against holding Euro denominated bonds and against having separate exposure to any continental European Stock Market. We also sold a bit of world equity elsewhere for clients who were at the top of our recommended exposure ranges. We continue with our balanced portfolios, rather than going completely into cash. We expect the world authorities to continue to muddle through with the measures needed to prevent a second major Credit Crunch, and to keep interest rates at penally low levels in the west whilst the difficulties remain this intense.  
 

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