Saturday, December 30, 2006

The market is climbing a wall of money

Ever hear of a dram shop? Guambat hadn't when he first came across the term early in his legal education some few decades back. He'd been in them, mind you, but didn't know them as such. He came across the term in the context of so-called "dram shop acts".

The term was new, but the basic notion is old: if a barman keeps selling liquor to an obviously drunken customer, the barman must share in the responsibility for the harm the drunken fool may cause. Since courts were slow to afix that liability, states began enacting dram shop acts to do the job.

In the world of finance there are no dram shop acts to put the onus on the purveyors of the market's tonic of choice, easy credit. If there were such laws, you'd think some very big names might end up in the clink, starting with the Central Bankers like Alan Greenspan, he of the Greenspan put legacy, who have continually spiked the punch to make sure the markets get all the liquidity/punch/accommodation they can handle -- and more.


Central banks should pull back monetary growth, writes Samuel Brittan


Monetary analysis has recently made a comeback because of many signs that, in their efforts to avert recession early this century, central banks permitted an excessive expansion. One of the best explanations is given by Andrew Smithers, the City of London economist, in his report World Liquidity. He notes that the ratio of US broad money to GDP is higher than at any time, with the exception of the 1930s slump and the second world war. Eurozone money supply growth is well above its "reference range" and British annual broad money growth is at its fastest since 1990. The Organisation for Economic Co-operation and Development has just published estimates of "global liquidity" based on both money and credit measures that show it is "abundant and continuing to grow".
The rush is on, the ride is wild by Kirsty Simpson and Rod Myer
A TIDAL wave of money has swept through financial markets in 2006 [see]. Driven by surging profits, cheap debt, low corporate gearing levels, vast pools of superannuation and rising interest from private equity, Australian companies are falling like ninepins. Qantas is just the latest in a long, long list.

The new millennium's corporate raiders have been able to find ways around regulatory impediments: clever reshuffling of assets can conquer Australian Competition and Consumer Commission commitments and issues such as national interest tests. Foreign ownership caps are but intellectual exercises to be conquered by an army of merchant bankers, advisers, accountants, lawyers and their financial backers.

Australian assets are being bought, sold, merged and carved up at an unprecedented rate, with competitors seeking to consolidate and private equity groups roving across the corporate landscape.

Compare this with another legendary boom, that of the mid 80s: In 1986, $9.6 billion-worth of M&A deals were announced, rising to $11.7 billion in 1987 ahead of the October sharemarket crash.

But the financiers and advisers behind the current boom insist the differences between the two eras are substantial and the good times rolling today are on a more solid footing, thanks to the health of the corporate sector.

Goldman Sachs JB Were chief operating officer Craig Drummond says there is a greater depth to financial activity now, both in the number of sectors involved and a broader number and style of raiders. [Safety in numbers?]

"In the 1980s it was a relatively narrow group of bank-funded entrepreneurial groups," he says. "Today, it's a lot broader (with) both the acquirers and the companies. The other issue is that the corporate and economic fundamentals remain quite robust, and again it's somewhat different to the 1980s.

"In the past we have seen one or two sectors alight, but here we've got (activity) from financial services to infrastructure through to transport, healthcare … It seems to be very broad-based corporate activity at this time. If you go back to 1986-87 when there was also significant corporate activity, it's quite different now.

"One, the private equity phenomenon is more prevalent. Two, corporate balance sheets are still considerably less geared than they were at that point in time. Three, we are seeing more genuine cash flow in pension funds. But also because of stock buybacks, large dividend payouts and the amount of corporate activity we are seeing a lot of that cash going back into the market or back into corporates."

Analyst Ian Greer of credit ratings agency Standard & Poor's agrees, saying the seeds of a crash may already be growing.

"They (private equity) are pushing the boundaries now. Things are very good in the debt markets. There's a lot of money available at low cost with few terms and conditions. It's pretty hot out there and the good times won't last. But you can't predict a turning point."

When the tide changes, it will be swift, Greer says, although there are far better risk management tools used now than in the 80s.

"My expectation is that any swing will be pretty harsh," he says.

This sort of prognostication is causing alarm amongst those financial editors whose job it is to sell papers, so they always have their fingers on matters of alarm, whilst keeping a careful eye always on their sponsors.

On a roll by Malcolm Maide
THE rise and rise of the sharemarket has inspired a new dinner party game — Guess What Year This Is. It's a game that gives grey-hairs an advantage, because the object is to place a boom that delivered a total gain of almost 19 per cent in 2006 in the context of the 1982-1987 bull market, when share prices soared, and then imploded.

That the game is being played at all underlines the similarities between this bull market and the one that ended traumatically in October 1987. Like the '80s boom, the current one began because company earnings could be bought cheaply, and continued as they expanded strongly. The sheer weight of investment money pouring into the market was a factor in the '80s, and is again today: baby boomers saving for their looming retirement are the new liquidity fountainhead, and the capital they are investing is being turbocharged by cheap loan money to finance a wave of leveraged takeovers led by private equity buy-out funds that again echoes the '80s.

Most observers think this resembles a 1986 market. After rising by 109 per cent since March 2003, share prices are high, but not yet nonsensically so, as they became in the first nine months of 1987, when Wall Street's S&P 500 leapt by 37 per cent, and Australia's All Ordinaries surged by 56 per cent.

A rise as substantial as that posted for 2006 may not be achieved in 2007, but a sharemarket meltdown is not yet being heralded.

Wall Street strategist Abby Cohen almost perfectly picked Wall Street's advance in 2006 for clients of her firm, Goldman Sachs, and she says more gains are in prospect. [Guambat has the suspicion she has picked every bull market that has come along, as well as a few which didn't.]

Cohen expects Wall Street's Dow Jones Average and the broader S&P 500 Index to both advance by about 10 per cent in 2007, building on gains of more than 16 per cent and 18 per cent respectively in 2006. She sees the market pushed higher in the new year as fund managers chase prices higher, adding momentum of their own, as private investors continue to bale out of housing investment and into shares, and as high cash levels in the market keep funding takeover activity, by private equity groups and corporate players.

The private equity funds here and overseas are a crucial new element. Their debt and equity reserves for takeovers and agreed purchases now exceed $US1500 billion ($A1905 billion), and investment money is still being heavily subscribed. Local deals including this year's unsuccessful $A18.2 billion tilt at the Coles group by a private equity consortium led by Kohlberg Kravis Roberts and a private equity-backed $A11.1 billion takeover of Qantas are promoting the theory that few large listed companies are not potential targets.

"There are similarities with the 1986-87 market," Citigroup analysts Adrian Blundell-Wignall, Alison Tarditi and Richard Schellbach told Citi's Australian clients late last month. "Moral hazard problems associated with private equity and the ready availability of liquidity, both here and globally, are driving up equity prices beyond reasonable returns, primarily in the industrial sector. Greed has become a factor … industrials are relatively very expensive."

The trio acknowledge, however, that the weight of money pouring into the market is a major, bullish, counterbalance. Australia's superannuation system is generating net flows of about $A48 billion a year, a third of which is being invested in shares. This is a pillar erected [by and for Wall Street] since the '80s boom and crash. Company dividends, cash takeover payments and share buyback payments are meanwhile generating record amounts that also need to be redeployed, and the share buybacks and private equity takeovers are simultaneously reducing the number of shares available. The Federal Government's new superannuation tax holiday is also attracting savings to the market, and the new Future Fund has injected liquidity. Citigroup's estimate is that about $A92 billion will flow into Australian-based managed funds in 2007.

Investors simply "cannot afford to be maximally bearish" when the weight of money is so heavy, Blundell-Wignall, Tarditi and Schellbach say, adding that in the absence of an external shock, the share price surge "could go on".

Meanwhile, the biggest sector in the Australian market, inspite of the dot-commodity boom, is the banking sector, particularly the big four. And the blush is coming off that bloom, according to some.

Dream run for big banks may be over by Richard Gluyas
FOR 15 years, the nation's banks have feasted on a diet of uninterrupted growth, increasingly benign credit conditions and, currently, a 30-year low in unemployment.

In recent weeks, warning bells have begun to sound about bank earnings, starting with a profit downgrade in late November from Adelaide Bank - the industry's first since National Australia Bank's currency options crisis of 2004.

Then, in mid-December at the ANZ annual meeting, Mr McFarlane warned that profit growth would be crimped because of higher bad-debt provisions and less demand for credit, with mortgage growth of around 20 per cent several years ago sliding into the low teens.

Goldman Sachs JBWere nominates a rise in bad and doubtful debts as the biggest risk to bank earnings over the next three years. To put it in perspective, it has been estimated that a return to a normal level of bad debts would slice 5 per cent from the industry's earnings per share.

However, the potential is there for greater damage, given the record level of household debt and rising interest rates.

JP Morgan analyst Brian Johnson downgraded the entire banking sector at the end of the profit reporting season in November from overweight to underweight.

As justification, he points to "valuation extremes", or very high price-earnings ratios, as well as the risk to earnings posed by the mortgage slowdown, increased competition, a realisation that loan losses must rise, and growing capital expenditure requirements as the banks invest in more staff and improved branch networks.

"To some extent," Mr Johnson said, "the premium rating of Australian banks relative to banks in other countries can be justified, given the oligopoly industry structure, which should continue to deliver strong earnings growth and superior asset quality.

"However, this oligopoly pricing structure is under serious pressure from politicians, regulators, new entrants, increasing third-party origination and predatory pricing amongst the banks themselves."

And the pressure on the new globally connected system of finance is building with no evacuation plans on the books.

Institutions can't cope with a crisis * The world's outmoded financial structures were not designed to meet the needs of globalisation, writes economics correspondent David Uren
NATIONAL Australia Bank chief executive Michael Chaney put Reserve Bank governor Glenn Stevens on the spot at his recent speech to Committee for Economic Development of Australia.

"If you think about the international interdependence of financial institutions now, of the counter-parties all over the world in all sorts of transactions, I wondered whether you could tell us about the international institutional structures that exist to be able to react that quickly in the event of a crisis?" he asked.

Glenn Stevens could not.

"As far as I know, I'm not sure there is a terribly well developed set of protocols that we know that's in the top drawer and we get it out and just follow it."

"We know who to call and who are our opposite numbers," he added hopefully, but he conceded there was much more work to be done.

Chaney identified a problem that is troubling finance leaders around the world. Institutions designed to manage the demands of globalisation do not exist.

It is significant that the institutions we have were built immediately after the economic and social catastrophes of depression and war, not the sunny prosperity we enjoy today.

The institutions built from the rubble of World War II are no longer fit for the purpose, and are losing commitment both from the nations that were their creators and from those who have joined since. This was a theme picked up by Bank of England governor Mervyn King in a speech to the Melbourne Centre for Financial Studies last week.

King has characterised the past decade as "the great stability". Inflation and unemployment have been low around the world. Interest rates, both long and short, have fallen while profitability and growth have soared.

Financial market volatility has been eerily low, bar the odd perturbation - such as one in May this year when long-term rates briefly rose, knocking emerging markets and currencies like the Icelandic krona and the New Zealand dollar for six.

There are some who argue that the world is working just fine without the interference of global institutions. [Unless, of course, we refer to global institutions the likes of Goldman Sachs or JP Morgan, Citigroup, etc.]

Central banks are committed to inflation targets and, for the most part, floating exchange rates. Current account imbalances, which were an overwhelming preoccupation in the immediate post-war era, appear to be consistent with sustained growth.

The argument is that markets work. Even the much-maligned hedge funds may be contributing to global stability, providing liquidity and absorbing shocks.

But the mere fact that the chairman of NAB is worried about the implications of counter-party risk, and that the Reserve Bank governor is unable to provide reassurance, suggest that the stability of the world financial system may be more apparent than real.

"The frenetic activity of international meetings and the flattering illusions of a stream of communiques do not add up to a coherent set of commitments," King says.

The G20 has been styled as a group that could co-ordinate action in the event of the financial crisis feared by Chaney, but it really delivers no more than personal relationships between financial leaders.

The problem is that the great stability has made nations complacent about the risks, just as the Reserve Bank frets it has contributed to the myopia of individual investors. [And thus the reference to dram shop acts at the beginning of this post.]

But while the handwriting may be going up on the wall, the partying is still going on down the hall.

Rate rise not impacting on credit demand
Higher interest rates have so far made little impression on consumers with the annual pace of credit demand remaining at a three-and-a-half year high in November.

The central bank raised interest rates for a third time this year in November as it continued to grapple with inflation as the consumer price index remained well above its 2-3 per cent target.

Total credit grew 1.1 per cent in November after climbing by 1.2 per cent in October following revisions, keeping the annual growth pace at 15.0 per cent for a second consecutive month, the highest level since mid-2003.

"Today's strong credit data demonstrates continued resilience in new lending," said Westpac analyst David Goodman.

Credit for the purpose of housing rose 1.0 per cent in November, to be 14.5 per cent higher than a year earlier, and down slightly from the 14.6 per cent recorded in the year to October.

Personal credit rose 1.1 per cent in the same month, lifting the annual rate to its highest level in just over a year at 11.4 per cent, up from 10.8 per cent as of October.

November business credit was up 1.2 per cent for an annual rate of 16.6 per cent, after growing by 16.7 per cent in the year to October.


This may help to sustain the Australian banks as they head into 2007, but it raises questions about how they might end 2007 if the UK is any guide.

Creditors write off UK record 1.4 bln stg of personal debt
The bad debts were written off after people signed up for Individual Voluntary Arrangements (IVAs) -- a formal agreement between a debtor and a creditor setting out repayment arrangements, usually lasting five years -- according to a study by accountancy group KPMG.

People as young as 21 are running up debts that are typically three times their annual income, with the average IVA debtor owing 52,000 stg proposing to repay only 39 pct of this sum, KPMG said.

KPMG estimated that more than 3,000 people entered into IVAs with debts exceeding 100,000 stg in 2006.

'Too many people have debts that they have no realistic hope of repaying,' the group said.

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