Frugality Returns

August 2008 Dr. Hans Black

Barely a year has passed since global financial markets were forced to reckon with a rapidly deteriorating environment. After the warning signs of early 2007 that something was going wrong in the U.S. mortgage market, by mid year 2007 the closing down of two prominent Bear Stearns hedge funds caused many to pay closer attention. Within weeks the environment dramatically changed and investors were forced to come to terms with a number of new realities. First of all, complex instruments which were designed to securitize all sorts of credit exposure to a larger number of end holders suddenly lost their liquidity. This rapid drying up of bids for instruments known as CDOs or CDOs Squared began to cause real havoc in the early days of August 2007. At this point it became quickly apparent that the beginnings of a global liquidity crisis were upon us. As this is being written, one year later, many things have gotten a lot worse and we would be the first to admit things have progressed rapidly – even beyond our wildest imagination.

The melt down in global financial stocks is perhaps the most dramatic illustration of how quickly things can go terribly wrong. Most of the world’s major banks have suffered horrific losses and with it dramatic share price declines. There have been few exceptions. Most dramatic and, of course, capturing headlines have been the declines in shares of Citibank, Wachovia, Royal Bank of Scotland and, of course, UBS. By mid July 2008, losses of 80% in a number of bank shares were not uncommon. Also by mid July 2008 an entire collection of companies, such as mortgage insurers and, finally, the core U.S. government sponsored enterprises – Fannie Mae and Freddie Mac – were very much in peril. Just barely four months after the dramatic last minute resuscitation of Bear Stearns, the U.S. government had to act again – this time to ensure that both Fannie Mae and Freddie Mac would not collapse. It should also be noted that these events in early July of this year followed the collapse of IndyMac Bancorp in California on the weekend of July 4th. While bank failures are certainly not unknown, IndyMac represented the largest banking institution to fail in well over a decade.

The perception by many that the U.S. government keeps bailing out these institutions is only partially correct. It cannot be over emphasized that investors in many of these institutions were in fact the biggest losers. Just ask any shareholder of Bear Stearns about the so called "government bailout". Watching your stock go from $80 just two weeks prior to the melt down and finally reopen at $2 or $3 before eventually settling at a higher price around $10 when JP Morgan bought them out, was not comforting. Equally it should be noted that shareholders of institutions such as IndyMac got nothing and the millions of shareholders in Fannie Mae and Freddie Mac have permanently lost their shirts. Talk of government bailouts, therefore, is very misleading, as so far we believe that what has occurred is largely and quite correctly so, last minute distress fence mending in order to keep the system going. Nothing could have been more telling than the anxiety which existed in the caucus room of the Senate Banking Committee on July 15th, as members of the U.S. Senate threw verbal bombs at Mr. Bernanke, head of the Federal Reserve Board, and his colleague Mr. Paulson from Treasury, as well as Mr. Cox, head of the SEC. The tension in the room was palpable and the air very thick, probably with disgust as to how all of this could have happened so quickly.

It is also becoming clear in Washington that the North American consumer, who has had to weather this financial storm on top of dramatic increases in energy prices, has been seriously hurt. Dramatic increases in food costs have also not helped. Consumers have been faced therefore with a rapid sequence of events – declining value in their home, declining value in their stock savings and far less purchasing power. Although it will never be known for sure, some time in June of this year something finally clicked. The consumer in the United States, and indeed many other countries, has suddenly changed his pattern and seems to be intent on repairing his damaged balance sheet. The use of the automobile in order to commute declined, restaurants began to report weakening traffic and finally retailers began to scream about the combination of fewer consumers and dramatically more frugal ones. In the past two months a number of national restaurant chains as well as consumer retail chains have gone bankrupt, as well as a whole host of companies reporting much less traffic through their stores. Even grand old Costco, so well positioned to take advantage of consumers searching for price efficient ways to shop, has not gone unscathed.

Sales of new automobiles have also plummeted in recent months; led, of course, by the infamous SUVs and new light trucks, U.S. car makers have been hurt the most. It should be noted, however, that in recent weeks the likes of BMW and also Japanese car makers have warned of the consequences of lower sales. Perhaps one of the most interesting recent stories is the ones where dealers now offer one month of free gas in order to entice purchases of their automobiles. It should be noted that car sales, both in Japan as well as in Europe, have also declined dramatically. As I keep reminding my friends in North America, gasoline in the United Kingdom goes for approximately $10 a gallon. We obviously have a long way to go. The long suffering airlines, increasingly overwhelmed by red ink, are charging economy fare passengers for checked luggage. Even the spectacularly successful European airline easyJet recently announced dramatically lower earnings amidst a sharp decline in passenger loads. Cruise ship companies have stepped up advertising with unbelievably low rates just to fill up empty space. Does all this mean that the G7 consumer is becoming dramatically more frugal? Eat at home, vacation with relatives and as seen recently in Chicago, so many people using the mass transit system instead of the automobile, thereby causing rail cars to be literally jam-packed.

We have commented for years on the possibility of a major consumer retrenchment, certainly in North America, but probably in many other G10 countries. We seem to now have arrived at that juncture. The good news is that the U.S. trade imbalance will correct itself very quickly. In addition, high prices for petroleum products will stimulate rapid implementation of alternative energy strategies. Mr. Boone Pickens, who has been very vocal in his advocacy of wind power, will likely be proven correct, as there seems to be a rapidly emerging consensus for the need to adopt different energy sources. Within 24 months commercially mass produced electric cars will be available for North American consumers. Their acceleration statistics will be better than ever and recharging times will come down. Companies that can provide solutions, i.e. the technology for alternative or more efficient use of energy will thrive. Even nuclear energy, we suspect, will make a major comeback.

It will be interesting to watch what happens now in China as most of our friends will be receiving this letter just as the Olympic Games will start. How will the world perceive this emerging economic power and how successful will they be in pulling off these Olympic Games? We suspect that what we will be witnessing is somewhat of a high point for the Chinese economic expansion. Increasingly, we are seeing reports of major problems linked to crop failures, lack of water for proper irrigation and, of course, mass over production which is being ignored by banking officials, at least for now. The key question has been the same for many years: Will the dramatic slowdown for North American consumption and indeed European consumption mean hardship for the emerging economies, particularly China? We suspect this concern is real and that we will see far slower growth in some of the major emerging markets. August will, therefore, be a time to keep a close eye on China and how it is affected by a potential change in G10 spending habits. Frugality in the developed world is not good news for China or indeed other developing countries.

Changes in financial markets, like changes in history, however, do not occur overnight. Any meaningful changes in direction in the fortunes of a particular country’s or region’s stock market – like Japan in 1990, for example – take time to develop, and as serious as the current worldwide downtrend is, we will also inevitably have periods where things look somewhat better. Oil prices will likely decline somewhat from the recent weeks near $150, thereby giving financial editorialists something more positive to write about. However, we are struck by the confluence of events that began one and one-half years ago and have led to a very rapid deterioration in the health of many key financial institutions and, unfortunately, the health of many global consumers’ balance sheets. The upcoming U.S. election will also be key as the near term direction of tax rates and fiscal policy will be important benchmarks to watch in the coming months. While it is entirely too early to speculate on the outcome of such a process, we sense that irrespective of who takes office in January 2009, certainly higher levels of taxation to some degree will be in evidence. North American, as well as European and, of course, Japanese consumers will further slow down their spending over the next several years. This is largely due to the fact that, as in Japan in the early 1990s, we suspect that once you begin to change a long term behavioral process, it will take quite a number of years to correct it once again.