We expected the markets to experience another bout of selling in the September/October period. Little did we know that the selling would commence so soon. In US trading last night, Wall Street experienced a drop of around 3% and that quickly translated into a nasty day today in Australia.
The selling is being driven by the process of deleveraging, something we have discussed a number of times in our weekly reports and daily blogs. Our view has been that the anticipated increase in volatility over the critical September/October period would lead to a rise in investor fear. With daily moves of 3%, this process is clearly underway.
Most recently, the deleveraging/fear effect has spread to the resource sector. Recent news that a large resource based hedge fund was liquidating its assets increased concerns about the commodities bull market. You can be sure that there are other hedge funds in trouble, and we have no doubt that many others are liquidating assets in order to meet expected redemption requests.
Bill Gross, Managing Director of Pimco, the world’s biggest bond fund, added to the market’s woes last night by publishing his monthly commentary. We follow Bill’s words closely. We have a similar view of the macro picture and his most recent commentary is in our opinion a perfect example of what is happening in the market right now.
The major point Bill makes is that the government needs to step in. He talks of the system needing a ‘new balance sheet’ - a source of new and unlimited funds to recapitalise the financial system.
This has always been our view of how the situation would play out. Granted, we did not expect equities to be savaged as bad as they have been but we feel we are reaching a point where the Fed and Treasury will have to step in and provide credit to a shrinking credit market.
In our daily blog, we have noted how government support packages are already beginning to emerge in China and Japan. For now, the interest rate tightening cycle has ended and it will not be long before global central banks are in easing mode.
In terms of commodities, we believe we are still in a secular, or long term, bull market. Right now, we are in the midst of a nasty cyclical correction, and the credit contraction is exacerbating the effect on resource related stocks, especially at the smaller end.
The important thing to understand is that secular bull markets do not go up in a straight line. Corrections must occur and must be deep enough to have the majority of investors believe the game is over. The bull market will only resume after the majority of investors concede that the bull market is over.
We’re not there yet but news that hedge funds are forced sellers of assets because of poor performance and redemption requests suggests we are nearing that point.
Here’s just a quick example of why we think the resource bull is not over yet. This year, BHP is expected to grow profits from US$15.4 billion to around US$24 billion, a massive 50+% increase. The main reason for the profit jump is because of big increases in iron ore and coal prices.
This is primarily why our terms of trade have increased sharply and why the reserve bank is reluctant to slash interest rates too quickly. These vast inflows of funds filter down through the economy via increased investment, wages, and profits.
In summary, today has been a bleak day on the market but we think the sell-off is a necessary precursor to government intervention and a sharp rally later in the year.
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