Fund Manager
What began as a healthy correction in the sub-prime segment of the mortgage market in the U.S., accelerated last week, and spiraled into a worldwide crisis of confidence in the global world of banking and finance. The proverbial “run on a bank”, in this case, a run on the financial system, forced the U.S. Federal Reserve to take the unusual move of lowering the discount rate, the rate at which the banks can borrow from the Central Bank. Given the Fed’s view of “deteriorating financial market conditions” and the increasing risks to the growth picture, the Fed signaled it would also be ready to cut its main interest rate as well.
Last week’s action reminds us of how fragile the financial system is, not withstanding the strong economic fundamentals. Yes it is true that the Western economies of North America, Europe and Japan are growing at 2-3%. Latin American economies this year have been growing in the 4-7% range while those of China and India have been even stronger. Corporate Earnings have also been healthy, growing at double digit rates, while corporate balance sheets have never been better.
One problem is that securitized assets have found their way into many hands. Hedge Funds, Pension Funds, traditional Mutual Funds, as well as corporations and individuals bought large quantities of asset-backed paper. Investors are today questioning its value as the associated risks are very difficult to measure. As liquidity has dried up and extension options have been exercised, one risk to the system is that “near cash” has been termed out over a year or more. Also, the possibility of default on AAA rated paper exists is liquidity back-stops are not (or can’t be) honoured .
The last weeks of August will be crucial for Ben Bernanke (Fed Chairman) and his central bank colleagues from around the world. The Fed originally chose to stay on the sidelines and welcomed the early correction and panic in the collateralized debt instruments as it would bring back logic and sanity. Refusing to bail out the greedy purveyors of these products, the Fed may have waited too long, according to some. Unlike the debacle of 1998 that required the bail-out of troubled Hedge Fund, Long-Term Capital (and of many emerging nation governments), today’s crisis touches many. Even “small Mom & Pop” investors with monies in Money Market Funds may find themselves with less liquidity and capital than they had previously planned for.
When confidence comes back, the dust will begin settling again, and investors’ time horizons will lengthen, and bids will re-appear. We don’t expect the market to bounce back to previous high soon, as it has during the previous dips, as real pain has been inflicted to the debt side of the investment world.
If Central Bankers can instill calm through liquidity and lower rates, then the world economy could be better off in the longer run, in a saner and lower interest rate world. The massive capital spending cycle worldwide, as a result of the industrialization of the emerging nations should continue to drive world economic growth and drive the commodity cycle further.
In the meantime, we have kept large cash balances through this correction. There’s a saying that “portfolio managers like volatility, until they actually get it”: while some of the swings over the past few weeks have been gut-wrenching, over time they could also represent great buying opportunities.
We have seen some trusts and stocks come back to levels that begin to interest us. We like Rogers Communication Inc.’s earnings growth, improving credit profile and dividend growth. Certain companies with exposure to the global agricultural industry stand to benefit from the growth in demand for grains. This growth, driven by larger and changing diets (more meat consumption in developing countries, etc.) will likely continue beyond this current financial crisis.
We have also seen some quality REITs come back to levels where they trade at a discount to their Net Asset Value—even if the NAV is stress tested for moderately higher borrowing costs. With some of the take-out premium leaving the market, some business trusts are, for the first time in many months, beginning to be priced in line with their fundamentals. We also note that the CDO equity pieces that we own—a small percentage of the fund—will see their cash flows increase over 20 percent as a result of the spread widening over the last month.
What we do know amidst this uncertainty is that we won’t be able to call a market bottom; however, this is not something we spend much time trying to do. We know that it’s unlikely that this current credit crisis will right itself in only a matter of weeks. But by focusing on the fundamentals of the various instruments in which we invest, we believe that we will continue to deliver good risk adjusted returns over time.
Eric Dzuba
Associate Portfolio Manager
Front Street Long/Short Income Fund