Building a Financial Panic Room

When exactly the share market bottoms and rallies now depends on the depth and severity of the recession Australia faces. Unfortunately, the recession hasn’t even really begun yet. That means stocks could face a long march through no-man’s land before finding their footing again. How long?

Try a year, or two. Jobless claims in the U.S. came in at their highest level in sixteen years. U.S. home prices probably have another 15% to fall (nationwide, although they are already down 40% or more in some places). If you believe the retailers, who are tugging at their collars and mopping their sweaty brows, there may be a huge collapse in household consumer spending.

There are several threads to untangle from this observation. The first is economic. A year ago, there were many observers that believed emerging markets and resources would survive an American recession and keep on keeping on. Your editor was one of them. We were wrong.

The tightness in credit markets that originated with bad subprime loans has gone global and moved across the whole portfolio of credit-related securities. Corporate bonds…commercial real estate…margin loans…leverage loans…student loans…auto loans…commodity futures. The whole universe of assets that was created in the big financial bang era of 1% nominal interest rates in 2003 is now contracting back on itself.

Thus, Australia didn’t suffer hugely from subprime flu (although the banks and some councils faced losses). But we found little galaxies and planetary systems full of exotic credit-related products that cannot survive the black hole of liquidity disappearing from our financial universe. Allco, ABC Learning, Babcock and Brown, they’re all disappearing in the liquidity black whole.

Ashes to ashes. Dust to dust. Energy to matter and back again, except in this case, the capital is simply destroyed rather than becoming energy. That is the real cost of credit bubble. Capital becomes scarce. Good projects can’t get money. The government sucks up the world’s remaining savings to borrow for its inefficient stimulations.

It is a world in 3D-deleveraging, deflation, and depression. Financial markets witnessed the first loss of liquidity which led to deleveraging. That gives you U.S. stocks at five year lows and the main Australian indices breaking through technical resistance at 3,500. What makes it so unpredictable now is that in a balance sheet recession, what causes a given firm or trader to reduce his assets by selling them is nothing predictable.

Insurance companies, pension funds, college endowment, super funds…they all have their own private balance sheet catastrophes. What they have in common is that every one of them is going to pick up the phone at some point and say “sell.” This is why you see historic volatility on the indices.

The deflation is taking us back to mid 1990s levels on stock markets. It connects to the real economy when firms have to cut costs to try and shore up the balance sheet. Reduce expenses. Fire people. Reduce inventories. Thus falling consumer and producer prices.

But sacked employees are consumers. And not only will they roll back consumption when they leave the work force, but the entire process of deleveraging and downsizing has a psychological effect on everyone else left in the work force. Seized with fear, consumers go on strike. They save. The economise. Private demand collapses. Depression ensues. The world in 3D.

What can you do in this situation? For the last week, construction crews have been drilling, excavating, and digging in one of the flats next to Old Hat Factory. The din is persistent annoying. We wondered what must be going on. Then it hit us. They are building a financial panic room.

What is a financial panic room and what goes in it? Well, it’s a room in which you could put all your assets to ride out the duration of the bear and the depression. They would be safe and some secure from further damage. You would also have water, tinned food, and some good books (The Law by Bastiat, Human Action by Mises, What Has the Government Done to Our Money by Rothbard, and Twenty Thousand Leagues Under the Sea, by Jules Verne).

Building a safe panic room is easier said than done. It depends on what kind of assets you have to begin with. At this point, you’d want to get into a discussion with your spouse, partner, financial planner or accountant on the right mix of assets. More cash, a lot fewer shares, some inflation protected bonds, a portfolio of premium stocks with cash and little debt, and of course, gold shares, gold coins, gold bullion, and gold jewellery. Also silver.

Your asset allocation is a highly individual subject though, and it’s not something we can advise you on. We would simply suggest it should be a matter of conversation (if you haven’t already made these decisions.) What about property, by the way?

RBA Governor Glenn Stevens tackled the issue during a Q&A session last night, according to He said the main difference between Australia in the U.S. is that the U.S. had a housing supply boom, which then led to collapsing prices when mortgage financing dried up with the credit crunch. Too many houses. Too few buyers. Cliff diving ensued.

“We didn’t build too many [houses],” Stevens said. “We’re probably not really building enough. That’s what most of the experts say. We certainly shouldn’t assume there is going to be a crash but some combination of a general decline in prices and gradual growth of income (was expected).”

He was referring to the large gap between average annual incomes and median house prices in Australia. The ratio between what Australians earn and what it costs them to get into the housing market is historically very high. You can bridge the gap with rising incomes or falling prices, or some combination of the both, which is what Stevens expects.

Our guess is that the fall in Aussie house prices is the next shoe to drop. Deleveraging has impacted commodity prices and shares. Stocks are cheap but could stay that way for a year or two. And that’s if they don’t retest the 2003 lows, which is entirely possible in a true global depression.

But you can’t have rising unemployment and falling household net worth and expect property to remain immune. We’re already hearing stories of high-end luxury property being battered. When the waves of the global recession start to get larger, we reckon they’ll erode Australian property prices faster than the ‘experts’ expect.

Finally, it looks like it won’t be until mid-2009 that inflation starts to show a heartbeat again. Things happen fast these days so it could come sooner. But it will take awhile before renewed fiscal stimulus starts coursing through the veins of the economy. The expansion of central bank lending and the growth in the Fed’s assets haven’t yet led to inflation because the money and credit created have gone to patch up corporate balance sheets, and not lent out back into the real economy.

To bypass this cash-hoarding preference of the banks, we expect to see more explicit government lending and spending in the next year. In the meantime, investors are rushing into U.S. bonds and notes and out of the equity market. Bond tracker funds and cash are popular.

If you were taking a contrarian punt this week, you’d go long the S&P 500 (or buy calls) and short bonds (where yields on 10-year U.S. notes are well below the rate of inflation). But you might also be crazy to do so. The ten-years are popular. They give the illusion of safety in numbers. But no real yield or capital gain.

Until next week…

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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There is change in soft commodities that may reveal opportunities off the back of low global inventories and a lack of liquidity to finance them and an abandonment of derivatives. Will the US and EU governments will be able to sustain their agricultural subsidies during a depression? Could the EU be destabilised by volatility coming from their new & only partially incorporated flanks? We have seen the chairman of Graincorp and Graingrowers no less quoted as saying he is personally storing on farm, not forward selling, and planning to contract directly with Japanese millers (to the detriment of his own… Read more »
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