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Monday, April 21, 2008

Black Clouds on the Economic Horizon


21 April 2008, Monday

The Economic Environment

3 In July last year, I warned that there were black clouds on the economic horizon, which could derail the “Goldilocks economy” which had lifted capital markets since 2002. The black clouds include credit tightening arising from the United States sub-prime mortgage crisis, rising inflation as a result of high oil prices and possibility of exogenous shocks like a terrorist attack. We were concerned that financial risks were growing dangerously in the capital markets. Excessive leverage in both the financial and household sectors had led to asset over-valuation. Risk premiums had been driven to extremely low levels in many credit and housing markets.

4 The ensuing unravelling in various asset markets was rapid and steep. The US sub-prime mortgage crisis triggered a major de-leveraging of the US financial and banking system leading to sharp sell-offs in equity and credit markets. The credit crunch, house price deflation and rising oil price worsened sharply in the first quarter of 2008 causing business and consumer confidence in the United States to deteriorate to recessionary levels. The financial contagion has now spread beyond US shores, increasing the likelihood of a global financial crisis and recession.

5 This led the US Administration and Congress to undertake a strong fiscal stimulus to bolster the economy. The US Federal Reserve has also taken radical measures to alleviate the contraction of liquidity in the financial markets. Just last month, the US Fed took the unprecedented step of taking over US$30 billion worth of credit risk onto its own balance sheet to facilitate the take over of Bear Stearns by J P Morgan Chase. This was to prevent a seizing up of the interbank and credit markets which could result from a massive avalanche of counterparty defaults.

6 Fortunately, GIC was well prepared as we had moved to a more conservative posture in our portfolio by liquidating a portion of our equity holdings in the third quarter of 2007 and moving into cash, a measure which we had not taken for quite some time. This provided us the liquidity to make substantial investments in UBS and Citicorp when these opportunities arose in December 2007 and January 2008. We regard our investments in UBS and Citicorp as long-term investments which will give us good returns when markets stabilise and economic conditions return to more normal levels.

7 Colleagues, we are now entering a period of extreme uncertainty in the world economy and the global financial markets. As banks continue to de-leverage, cutting down on their lending activities and causing contraction in credit supply, the prospects for the US economy and possibly even the world economy are fraught with considerable downside risks. We could be facing a recession which is longer, deeper and wider than any recession that we have encountered in the last thirty years. The economic downturn can be mitigated if decisive and timely actions are taken by policy makers in the United States and elsewhere. If policy makers respond strongly and appropriately, investment markets and sentiments can turn around sharply.

8 However, if such actions by the authorities are not taken within the next three to four months, it will be left to the market forces of supply and demand to stabilise the US housing market before we can see the light at the end of the tunnel. This will be a considerably more painful and long drawn process.

9 What is clear is that the financial and investment markets will be extremely nervous and volatile over the next one to two years. Instead of the rising tide which had broadly benefited financial and investment markets for the last ten to twenty years, we are now facing choppy seas which could engulf the broader economy globally. Policy makers, business managers and investors will require fortitude and nimbleness to navigate safely through the turbulence.