Fund Manager
Norm Lamarche
The governments inability to contain capital market issues, accentuated the spiral in September, sending share prices tumbling worldwide for the quarter. Government Treasury offices, as well as Central Banks worldwide, were forced to take greater remedial action to stem the contagion, as evidence mounted quickly of its spread into the “real” economy. Falling prices for energy, metal and grains led commodity share prices to sharp corrections during September. On the energy front, WTI crude dropped from $145/bbl in July to close just above $100 at the end of September. Natural Gas was cut in half, to close at $7.44/Gj. Both commodities today (at the time of writing) have a six handle (oil traded below $70/bbl). The metals side of the commodity group fared no better. The more economically-proned, the worse its outlook and stock market performance during the quarter. Even the Gold sector failed to provide any form of shelter during these unprecedented, turbulent capital market experiences. The price of Gold dropped 6%, while gold equity share prices dropped almost 26% during the quarter, as investors dumped all, and any type of resource shares.
Rather than share our views about how our Funds’ positions have been overdone, and that many are now trading at extreme low Price-Earnings ratios, low Price-Cash Flow ratios, below BOOK VALUES, below Net Asset Values, below REPLACEMENT VALUES and in many cases, below actual NET CASH VALUES, let’s focus on what’s taking place in the capital markets. The wholesale-like selling is occurring for three reasons. The first is a result of fear that the banking system worldwide is failing. The second is a result of the massive liquidation by managers facing redemptions, particularly from the Hedge Fund community. The third reason relates to the fear that the economy is weakening rapidly.
As for the banking system, Federal Reserve Bank Chairman, Bernake, has failed us by letting confidence spiral endlessly into a state of seizure! It didn’t have to happen this way, but it has. The original strategy of punishing the greed and purveyors of problems will end up costing all innocent taxpayers, as the Treasuries worldwide scramble to put forward costly remedial actions.
Central banks are not of “last-resort” anymore; they are the “only resort”, as the conventional system has seized up. The most recent tranche of medicine, beyond the guaranty of bank deposits and the Gazillion dollar illiquid paper bailout packages worldwide, is of most interest. Since it is the banks that got us into this mess, it will be the banks that will lead us out of it as well. The governments have, finally, in no uncertain terms, let capital markets know that what is left of the banking system will not fail, and they are, and will, throw everything at it. Of interest is the government guarantee over the next three years, of bank newly issued commercial paper and all unsecured debt financings. Pretty powerful, as banks will now finance their assets at Treasury-like rates. It is Treasury’s intention to create massive profitability margins at the Banks that will enable them to write off the things that aren’t working. While credit spreads have begun to tighten somewhat, investors should begin to see its greater impact over the next month as Banks begin issuing commercial paper again, but at very attractive rates to them. As for the gazillion dollar bailout funds, much of it will be used to buy out the most of toxic-illiquid paper off of the banks’ balance sheets, freeing up some liquidity. Of interest also, is the movement away from mark-to-market, towards other forms of cost-based accounting. Canada, in October, joined France in allowing banks and insurance companies to price their economic assets as though they are economic. Notwithstanding the accounting issues the future may bring, the change away from mark-to-market would free up substantial bank capital available for lending. There is no doubt that all of these measures will not only increase bank profitability, but more importantly, free up capital. The resulting uncertainty remains how quickly the banks will transfer that capital to the real economy.
While governments would prefer to see the banks’ fresh capital deployed as new lending in the weakened economies, the banks prefer the massive positive carry trade about to take place in the financial paper assets. The governments, as substantial equity holders of banks today, will likely use some form of moral suasion to convince them otherwise.
As for the redemptions in the equity markets, the Hedge Fund community has been the most aggressive, particularly in the credit, emerging and commodity-based sectors. The end of the calendar year is a period that many managers have been focused on to meet their liquidity needs. Much of the selling has also been front running the impending selling. Cash levels in the conventional mutual fund world are running at high levels. We anticipate that the liquidation selling will subside as the year-end approaches.
That leaves us with the prospect of a rapidly deteriorating economic outlook. The current round of economic stats, and for the next year, will continue to show the impact to the real economy. Consumption and Investment decisions have all been put on hold, until stability (and financing) prevail. Much of it will be lost until the next economic cycle. Some of it will return in a more normalized economic world order.
In the commodity world, the headlines and stats are pointing to demand in rapid decline, and rising inventories. Commodity prices have retrenched dramatically, some at levels testing economic viability of higher-cost operations. Companies like Chesapeake Energy have begun shutting in their high-cost and lower-priced natural gas production. Others like Russian-based Norilsk Nickel are evaluating their Australian and African operations. With commodity prices cut in half, all companies are re-evaluating their capex plans. Europe’s largest natural gas producer, Gazprom, is already walking away from planned projects. Many projects planned or under construction are being shelved or delayed as a result of the economic uncertainty or financing opportunities.
The emerging nations’ growth profiles are slowing. Some of the debtor nations (that have borrowed in foreign markets), particularly in Eastern Europe will be in need of IMF help to secure liquidity. The majority of the emerging nations, however, are well capitalized. As for our main theme, the Industrialization of the Emerging Nations, we should remind ourselves that it is not a recent theme. The ten years preceding the 98-99 currency-led, emerging nation downturn was similarly characterized by rapid economic growth of these nations, having a profound impact on all resource materials. The 1998-1999 downturn however, literally bankrupted many of those nations. They did however, outgrow their economic and financial distress and deliver another 10 years of growth that has continued to reshape the economic and geopolitical landscape to what it is today. While the emerging nations are clearly in better financial shape today, they nevertheless require a sound and growing western economy.
All commodity prices, particularly energy and food, have tumbled, making inflation of little concern. Expect more interest-rate relief as well. As for the stock market fundamentals, as we stated earlier, stocks are trading at extreme low Price-Earnings ratios, low Price-Cash Flow ratios, below BOOK VALUES, below Net Asset Values...
As investors worry about the banking system failing, and when much of the redemption-driven liquidity process runs its course, they should begin to compare the stock market valuations in this new economic reality. We think it’s been overdone. Watch for continued tightening of credit spreads as a precursor to a better stock market world.
Norm Lamarche
Portfolio Manager
Front Street Capital
NORM LAMARCHE - Q3 2008 COMMENTARY
Date Published
Fund Manager
The governments inability to contain capital market issues, accentuated the spiral in September, sending share prices tumbling worldwide for the quarter. Government Treasury offices, as well as Central Banks worldwide, were forced to take greater remedial action to stem the contagion, as evidence mounted quickly of its spread into the “real” economy. Falling prices for energy, metal and grains led commodity share prices to sharp corrections during September. On the energy front, WTI crude dropped from $145/bbl in July to close just above $100 at the end of September. Natural Gas was cut in half, to close at $7.44/Gj. Both commodities today (at the time of writing) have a six handle (oil traded below $70/bbl). The metals side of the commodity group fared no better. The more economically-proned, the worse its outlook and stock market performance during the quarter. Even the Gold sector failed to provide any form of shelter during these unprecedented, turbulent capital market experiences. The price of Gold dropped 6%, while gold equity share prices dropped almost 26% during the quarter, as investors dumped all, and any type of resource shares.
Rather than share our views about how our Funds’ positions have been overdone, and that many are now trading at extreme low Price-Earnings ratios, low Price-Cash Flow ratios, below BOOK VALUES, below Net Asset Values, below REPLACEMENT VALUES and in many cases, below actual NET CASH VALUES, let’s focus on what’s taking place in the capital markets. The wholesale-like selling is occurring for three reasons. The first is a result of fear that the banking system worldwide is failing. The second is a result of the massive liquidation by managers facing redemptions, particularly from the Hedge Fund community. The third reason relates to the fear that the economy is weakening rapidly.
As for the banking system, Federal Reserve Bank Chairman, Bernake, has failed us by letting confidence spiral endlessly into a state of seizure! It didn’t have to happen this way, but it has. The original strategy of punishing the greed and purveyors of problems will end up costing all innocent taxpayers, as the Treasuries worldwide scramble to put forward costly remedial actions.
Central banks are not of “last-resort” anymore; they are the “only resort”, as the conventional system has seized up. The most recent tranche of medicine, beyond the guaranty of bank deposits and the Gazillion dollar illiquid paper bailout packages worldwide, is of most interest. Since it is the banks that got us into this mess, it will be the banks that will lead us out of it as well. The governments have, finally, in no uncertain terms, let capital markets know that what is left of the banking system will not fail, and they are, and will, throw everything at it. Of interest is the government guarantee over the next three years, of bank newly issued commercial paper and all unsecured debt financings. Pretty powerful, as banks will now finance their assets at Treasury-like rates. It is Treasury’s intention to create massive profitability margins at the Banks that will enable them to write off the things that aren’t working. While credit spreads have begun to tighten somewhat, investors should begin to see its greater impact over the next month as Banks begin issuing commercial paper again, but at very attractive rates to them. As for the gazillion dollar bailout funds, much of it will be used to buy out the most of toxic-illiquid paper off of the banks’ balance sheets, freeing up some liquidity. Of interest also, is the movement away from mark-to-market, towards other forms of cost-based accounting. Canada, in October, joined France in allowing banks and insurance companies to price their economic assets as though they are economic. Notwithstanding the accounting issues the future may bring, the change away from mark-to-market would free up substantial bank capital available for lending. There is no doubt that all of these measures will not only increase bank profitability, but more importantly, free up capital. The resulting uncertainty remains how quickly the banks will transfer that capital to the real economy.
While governments would prefer to see the banks’ fresh capital deployed as new lending in the weakened economies, the banks prefer the massive positive carry trade about to take place in the financial paper assets. The governments, as substantial equity holders of banks today, will likely use some form of moral suasion to convince them otherwise.
As for the redemptions in the equity markets, the Hedge Fund community has been the most aggressive, particularly in the credit, emerging and commodity-based sectors. The end of the calendar year is a period that many managers have been focused on to meet their liquidity needs. Much of the selling has also been front running the impending selling. Cash levels in the conventional mutual fund world are running at high levels. We anticipate that the liquidation selling will subside as the year-end approaches.
That leaves us with the prospect of a rapidly deteriorating economic outlook. The current round of economic stats, and for the next year, will continue to show the impact to the real economy. Consumption and Investment decisions have all been put on hold, until stability (and financing) prevail. Much of it will be lost until the next economic cycle. Some of it will return in a more normalized economic world order.
In the commodity world, the headlines and stats are pointing to demand in rapid decline, and rising inventories. Commodity prices have retrenched dramatically, some at levels testing economic viability of higher-cost operations. Companies like Chesapeake Energy have begun shutting in their high-cost and lower-priced natural gas production. Others like Russian-based Norilsk Nickel are evaluating their Australian and African operations. With commodity prices cut in half, all companies are re-evaluating their capex plans. Europe’s largest natural gas producer, Gazprom, is already walking away from planned projects. Many projects planned or under construction are being shelved or delayed as a result of the economic uncertainty or financing opportunities.
The emerging nations’ growth profiles are slowing. Some of the debtor nations (that have borrowed in foreign markets), particularly in Eastern Europe will be in need of IMF help to secure liquidity. The majority of the emerging nations, however, are well capitalized. As for our main theme, the Industrialization of the Emerging Nations, we should remind ourselves that it is not a recent theme. The ten years preceding the 98-99 currency-led, emerging nation downturn was similarly characterized by rapid economic growth of these nations, having a profound impact on all resource materials. The 1998-1999 downturn however, literally bankrupted many of those nations. They did however, outgrow their economic and financial distress and deliver another 10 years of growth that has continued to reshape the economic and geopolitical landscape to what it is today. While the emerging nations are clearly in better financial shape today, they nevertheless require a sound and growing western economy.
All commodity prices, particularly energy and food, have tumbled, making inflation of little concern. Expect more interest-rate relief as well. As for the stock market fundamentals, as we stated earlier, stocks are trading at extreme low Price-Earnings ratios, low Price-Cash Flow ratios, below BOOK VALUES, below Net Asset Values...
As investors worry about the banking system failing, and when much of the redemption-driven liquidity process runs its course, they should begin to compare the stock market valuations in this new economic reality. We think it’s been overdone. Watch for continued tightening of credit spreads as a precursor to a better stock market world.
Norm Lamarche
Portfolio Manager
Front Street Capital