An asset class called “credit”, which was largely the creation of the past six years, has begun to blow up, says CLSA’s Christopher Wood in his client newsletter Greed & Fear. In Wood’s view, “this asset class is now in the process of self-destruction as the whole edifice of structured finance is completely discredited, and most particularly the illusion of liquidity it provided”.
The unwinding of the credit bubble is a “big-picture deflationary event”, he says, “which is why it is only a matter of time before the Fed starts easing.”
There remains “huge potential” for market panic because of the extent to which structured finance has entered the world of money-market funds. For now, Wood says darkly, “the world is nowhere yet near the peak of the fear that will be generated by the unwinding of the credit bubble”.
Equity investors should not underestimate the potential collateral damage from the unwinding of the global credit bubble, he warns.
The fundamental risk is that US consumers, as well as other leveraged consumers such as the British or the Spanish, are going to slow sharply, he warns. “This will hit Asian exports, which is not yet discounted in Asian 2008 consensus earnings forecasts.”
In Greed & Fear’s view, the current environment of falling government bond yields and rising credit spreads is negative for equities since it is deflationary market action. “The recent initial signs of a US dollar bounce is also a deflationary signal, notes Wood. His guess is that the dollar strength will persist until Fed chairman Ben Bernanke commits to aggressive easing. “At that point, gold’s time may well come”, says Wood.
Right now, there is potential for “significant further collateral damage for equities in general and Asia in particular”, he notes, reiterating his view that the worst case for Asia in this bull-market correction would, in the context of a real US recession, “be a one-third correction from the recent high.” The first obvious buying opportunity for Asia should be signalled by the coming Fed easing, says Wood.
The ultimate “solution” to the current spreading crisis will likely be forcing the banks to take back all the stuff they have “distributed”, says Wood. These banks will then be bailed out, save for a few scapegoats, “but only after equity investors have taken massive hits and managements have been purged”, he predicts.
In concluding, Wood shares his cheery prognosis that “people in America have lent recklessly against rising asset values, rather than against the cashflow that can be earned from the asset, and will now suffer the consequences. Credit will still be available in the US. But going forward it will be allocated on a much more rational basis”.
A final affectionate swipe at the credit rating agencies: In G&F’s view, “the financial world would be better off without credit rating agencies given the dangerous illusion of prudence and respectability they provide. A complete rating vacuum would make end investors focus much more healthily on caveat emptor.”
So there.
