TORONTO (GlobeinvestorGOLD)--I have lived through many financial crises including the stagflation of the 1970s, double-digit inflation in the early 1980s, collapse of Tokyo's Nikkei index, the recession of the early 1990s, and the dot-com bust that produced the bear market of 2000-2002. None of those approached this debacle in terms of magnitude. Warren Buffett called it "an economic Pearl Harbor" and the desperate actions being taken by politicians and central bankers around the world suggest he was not exaggerating.
Right now, the two greatest priorities are finding a way to end the credit crunch and calming global stock markets. But after we (hopefully) achieve that, what does the future hold? Just as Pearl Harbor and 9/11 changed the world, so will the crisis we are living through. Here are some of the things we might expect.
The decline of leveraging. One of the root causes of the mess we are in is leveraging – the borrowing of money on a huge scale by companies to finance acquisitions, business expansion, and investments in high-risk securities. Leveraging can dramatically enhance profits when things go well.
When the money is used to acquire assets that decline in value, losses are magnified and that it exactly what we have seen on a macro scale in the U.S. A comment on the website of money management firm Phillips Hager & North says we should expect regulators to place tight restrictions on the use of leveraging. "This is a game-changer for the U.S. financial sector as a combination of lower leverage and greater regulation means less risk, but also lower returns. The financial sector will become a safer, but perhaps less profitable, place," PH&N says.
This de-emphasis of leveraging will filter right down to the individual homeowner. For several years, some advisers have advocated borrowing against home equity to finance the purchase of a portfolio of mutual funds, stocks, etc. They backed up their proposals with figures showing how the use of leveraging would increase profits while the interest paid on the loan would be tax deductible. As an aside, the adviser would also collect healthy sales commissions on the transaction plus annual trailer fees on the funds.
In the light of what has happened, it's unlikely many advisors will be pushing the leveraging concept and if they do, it's doubtful people will listen. Real estate prices in Canada have held up well compared to those in the U.S. but there are signs the market is softening and we will likely see that pattern continue through the winter. That means there will be less home equity to borrow against and people will be more concerned about protecting what they have.
A new emphasis on safety. During the long bull market of October 2002 to June 2008, many investors forgot about the shock of the dot-com bust and allowed greed to come to the forefront again. Now that we have experienced two financial earthquakes within a decade, I doubt that will happen again any time soon. One bout of wealth destruction (2000-2002) might be dismissed as an aberration. It wasn't and this time it is even worse. I expect that in future people will be much more aware of the consequences of risk-taking and more likely to adopt a conservative approach to portfolio management.
Curbs on credit. The days of free-wheeling credit are over. We would never have gotten into this crisis had financial institutions (especially those in the U.S.) been tougher in evaluating credit risk and less willing to grant a loan to any warm body that walked through the door. We have already seen a tightening of mortgage lending rules in Canada, with perhaps more to come. That's only a mild preview of what I expect is in store for Americans.
Canadian companies have been as promiscuous as their U.S. counterparts (in some cases their parents) in soliciting credit card sign-ups. I was nonplussed when I received a telemarketing call from MBNA Canada in the midst of the bailout debate offering me a platinum credit card. They couldn't even pronounce my name but my credit was apparently good enough for them.
Last week, Royal Bank sent us a letter inviting someone who does not even exist to apply for a Visa card. (We used a made-up name for a telephone listing for our teenagers when they were living at home. The last one moved out more than a decade ago but RBC still wanted the non-existent "K.D. Pape" as a customer.)
If the banks don't do it themselves, regulators in the U.S. and Canada should put an immediate stop to unsolicited credit card offers. They are just one more example of why the debt pyramid has become so massive. And while I'm at it, we should also ban the unsolicited mailing of blank cheques to cardholders with an accompanying letter encouraging them to use them to draw against the account. Not only is this practice an incitement to add ever more debt but the interest rates charged on cheque withdrawals are almost usurious.
New emphasis on saving. Americans have been living beyond their means for years (collectively spending more than they earn) and Canadians have fallen into the same trap recently. Just as corporations cannot pile up debt forever, neither can individuals. I believe that we are going to see more emphasis on "putting something aside for a rainy day" as people realize the danger of overextending themselves. As it happens, the fortuitous timing of the introduction of Tax-Free Savings Accounts on Jan. 1 will make saving easier and more financially attractive.
The downside of a Saving Society is that it will be a drag on business. Consumer spending has been the driving force behind North American economic growth for decades. As more income is diverted to savings, spending will decline and growth will slow. It's sad that the virtue of thrift will contribute to what may be a prolonged period of economic stagnation, but that's the reality we face. What's good for a family is bad for the economy!
Lower interest rates. We've already seen a co-ordinated half-point cut from the central banks. There are probably more to come although the extent to which they are passed through to consumers is problematic. As we saw last week, the profit squeeze banks are facing has made it more tempting to keep some of any cut for themselves.
What should mutual fund investors do in the light of all this? I suggest putting more emphasis on top-quality bond and money market funds for the next several months. Reduce positions in equity funds – we are unlikely to see any prolonged stock market rebound until well into 2009. However, don't abandon equity funds entirely – there will be a turnaround eventually. We just don't know when that will be.
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