Might is right in battle to survive

Investors should eschew risky punts in favour of good quality companies with strong market positions and robust balance sheets - not least because recovery is predicted to take years.

The global economy has entered a co-ordinated downturn. Weakness initially evident in America, then Britain, has spread to the rest of the globe.

The speed with which the global economy has gone into a tailspin is startling. I have been for the past few years a proponent of “East over West” as an investment theme, based on China’s fast growth and apparently insatiable demand for commodities.

But through the summer China began to slow, because of softer export markets. And when power demand – the one thing for which there are good-quality statistics in China – began to fall, something dramatic was going on. China has re-coupled to the global economy with a bang.

Policymakers globally have created a flurry of initiatives in recent weeks as they struggle to get to grips with the developing crisis. Among the unintended consequences of this intervention, we might add – with the benefit of a few weeks’ hindsight – a sudden sharp slowdown in global trade. Why would this be, when governments are trying to solve the problem?Among all the policies developed in a hurry there has been a natural wish to avoid creating moral hazard, in which undesirable behaviours are encouraged through bailing out institutions that get themselves into trouble. Some institutions were nonetheless deemed ‘too big to fail’, such as Citigroup and AIG. Lehmans, by contrast, was allowed to go under. The cost of interbank lending, which had been stable through the summer, began to climb once more, as banks’ mistrust of one another grew.

At the same time global trade slowed dramatically. Letter of Credit (L/C) financing is key to international trade. A supplier in one country agrees to supply a quantity of goods to a customer in another country. Before the supplier loads it onto a ship, his bank obtains an L/C from the customer’s bank, effectively guaranteeing that the customer is good for the money.

After the failure of Lehmans, the L/C financing process began to fail. Suppliers’ banks did not have faith in the ability of L/C issuing banks, or their customers, to pay for goods shipped. The consequence: ships lie idle off ports around the globe, either empty or waiting to be unloaded, if or when payment comes through.

The world’s economies are all hit at the same time. The cost of chartering a Capesize ship has fallen from a peak of $234,000 (£129,000) a day a few months ago to $2,800 a day.

Banks are capital-constrained, risk averse, and unwilling to lend money to anyone but the most solid customer. Even when they do lend, they do not pass on the benefits of substantially lower official rates, unless instructed by their new shareholders – governments. With restricted access to funds, we borrow and consume less, and the economy slows.

The good news is that the cavalry is on the way – and they are bringing up heavy artillery. In America, the combined total commitment so far is $4.5 trillion. That staggering sum would have been more than enough in real terms to fund the events Event 2008 cost ($bns)Shows American government spending on various events in terms of billions of 2008 dollars. Source: Bianco Research/CNBClisted in the table. America has created its modern self, saved the world on several occasions (at least in the mind of Americans) and gone to the moon, all for less than the cost of the credit crunch.

So the American fiscal response has been nothing short of dramatic. And more is on the way, if the leaks about Barack Obama’s (America’s president-elect) spending plans are anything to go by.

China is also getting inShows monthly Chinese power demand in billions of kilowatt hours, from 2004 to 2008. Source: CEICon the act – an indication of how the country has been caught up in the world’s problems. China has announced a stimulus package worth about 15% of GDP, to be spread over two years. Even allowing for some double-counting, this is a huge figure. Alistair Darling’s 1% fiscal stimulus looks puny in comparison.

What about equity markets? They look cheap on most measures, but earnings and dividends are highly uncertain as the recession deepens.

In these circumstances, it is difficult to call the market direction in the short term. But the amounts of money being thrown at the problem will have the desired effect. Economies will recover – with a lag – and equities will anticipate the recovery.

The process of deleveraging will take several years, however, with borrowing difficult or scarce. In these circumstances investors should buy the equity “playground bullies”.

Quality companies with strong balance sheets, strong cash flows, and strong market positions will become more dominant. Stealing other people’s pocket money may not be pretty, but it will work.

“Economies will recover – with a lag – and equities will anticipate the recovery”


The process of deleveraging will take several years,
however, with borrowing difficult or scarce. In these
circumstances investors should buy the equity “playground
bullies”.


Quality companies with strong balance sheets, strong
cash flows, and strong market positions will become more
dominant. Stealing other people’s pocket money may not
be pretty, but it will work.