Markets rebound, but risks remain: Gottliebsen

The big rally in share and commodity markets tells us that the worst of the forced selling may be over and that the danger of a global banking meltdown is now dramatically reduced.

But those punting on this rally as a basic turning point in the sharemarket should be aware of several risks.

First, the US still has not put together its rescue package. If it is modelled on the British package, those banks taking the rescue medicine face a bitter pill as shareholder value is reduced, salaries are cut and the banks are told to go back to conventional banking by lending for houses and smaller enterprises. The shares in the “rescued” British banks fell sharply despite the overall sharemarket rise.

Second, the enormous loss of banking capital means that we are simply not going to return to anything like the easy times and the capital restoration process puts a lid on, or reduces the value of, many capital assets and curbs economic activity. In addition, there are many corporate nasties still to be revealed that are not accounted for in share prices. On the other hand, among those companies that can sail through the downturn, real long-term share buying value has been created.

There is no doubt that we avoided a banking meltdown only by a close margin. The combination of the implications of the Lehman failure and the need for hedge funds and other leveraged equity investors to liquidate their portfolios of shares and commodities produced a sufficient fall in the market to convince even the dumbest of politicians that unless they acted there would be a global depression.

When Wall Street was down 10% at one point on Friday, as the forced selling, fear-driven snow ball gathered momentum, we really flushed out a lot of weak holders, which was very healthy for the long-term market. A similar situation arose in commodities. We need to underline that the vast swings in the oil and copper prices do not reflect actual demand trends. The prices were driven up by hedge funds and other highly leveraged buyers and were driven down by their forced sales. While clearly there were movements in demand, they were not the main forces driving the price dramatic moves.

With the fear of a meltdown now reduced and a big chunk of the weak speculators forced out, it’s possible to be more rational about the likely future trends. Unless the US botches its bank rescue so that there is still grave doubt about US bank security, we are going to see a strong rally.

In line with previous experiences after a “day of no hope” (Friday), this is exactly what you would expect. However, when financial institutions have been deeply damaged and the confidence of consumers has been battered, the economy does not suddenly come back to its old path. Borrowing demand and bank credit criteria have been fundamentally changed. So in coming months we are going to see a lot of international companies report much lower profits than many of the Wall Street analysts are predicting. This will dampen enthusiasm for shares that have risen strongly in the recovery.

Here in Australia we will go through a similar process. Banks are a much bigger part of our market than in Britain or the US. The cost of the bank deposit guarantees will be a factor in assessing bank profits. There will be big bad debts to write off. However, because the banks are issuing government guaranteed paper, and the economy needs stimulation, interest rates will fall, which means that high yielding equity securities that are not in danger of seeing their income knocked around will benefit.

Prime Minister Rudd has made it clear that the economy will slow and there will be a crunch in more expensive houses, because incomes and lending will not be there to support the old values. Cheaper houses will be less affected.

Demand for commodities will be subdued and prices will be lower, but the Australian dollar is also lower. The stimulation being undertaken in China should help mineral prices once the forced selling is out of the market. However, there will be a big rationalisation of mineral expansion projects.

All this is exactly what has happened in past downturns. We have survived these experiences before and we will do so this time. What made this market slump different was the threat of a global meltdown. Subject to what happens in the US, that danger is passed.

This article first appeared on Business Spectator