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Barron's has
done it again. Two weeks before plunging to a 55-year-low, the financial
magazine's cover story was "Buy GM." Last week the cover story was
"Bye, Bubble? The Price of Oil May Be Peaking."
At the end of March the cover read, "Commodities: Who's Behind the Boom?"
a story in which the tagline was "small investors have driven commodity
prices to levels that can't be supported for much longer." And this
week-the cover story title reads, "Future of the Street." It
attempts to make the point that "Wall Street is likely to reinvent
itself in coming years - and emerge stronger that before the current crisis
hit."
And we
thought that the Federal Reserve was the gang who couldn't shoot straight. To
the defense of Barron's and the author, this weeks' story reflects the
collective prevailing views of how industry leaders and participants think
the current downturn will play out. The magazine also included a powerful
counter-story (unlike when they ran the Commodities story on March 31)
titled, "Why the Rout in Financials Isn't Over,"
packed with convincingly strong technical trend data from the highly-regarded
Louise Yamada who postulates that price levels of investment banks have much
further to plunge.
The popular
belief, however, is captured well by this week's Barron's cover story:
First, there will be more layoffs, pain, and suffering but a turnaround will
inevitably come. Second, The De-securitization and De-leveraging processes
are underway and will eventually play themselves out. And third, products
will become simpler, and less customized.
There have also
been a slew of stories making the case that the Manhattan real estate market will escape
the steep declines encountered in other markets around the country. Andy
Sewer wrote a commentary which appeared in last Sunday's Washington Post
titled, "The Street Sleep, the City Shrugs," stating "...in
fact, Manhattan
is still very much in the swim." One of Sewer's strongest points is that
the decline of the US dollar relative to the Euro will entice Europeans and
other foreigners to continue to shop in Manhattan
and buy real estate there. That alone should provide a considerable bid on
prices. His second point, that "so much profit has been made on Wall
Street over the past 2 ½ decades that the amount of money sloshing
around is likely to keep the price afloat indefinitely," might not hold
up as well if there is any sustained plunge in asset prices (stocks and
bonds).
So basically
the view is there will be layoffs and tough times, perhaps even tougher for
the more highly-paid segment this go around, but, just as had occurred in the
past, the industry will learn from its excesses, innovate and reinvent as
necessary, and layoff too many people which will result in another boom and
feverish hiring once the industry turns around. Sorry, but that sounds a
little too complacent for me. In the past I think there was more of a sense
of fear and that the jobs would not be coming back.
I think that
the industry is missing two major points. One, there is an under appreciation
for the longer term effects of cutting back on securitization and
deleveraging. Two, alternative financial markets and centers are springing up
in different parts of the world. London
is already recognized as being on par with Wall Street. I expect that both
will cede supremacy to China
over the course of the next couple of decades.
Regarding the
first point, in an April 28 Bloomberg article titled, "Danger Ahead: Fixing Wall Street Hazardous to Earnings Growth,"
the authors opine:
Wall Street's money-making
machine is broken, and efforts to repair it after the biggest losses in
history are likely to undermine profits for years to come...No one is sure
the model works anymore. While Wall Street executives and regulators study
what went wrong, there is no consensus solution for restoring confidence.
Under review are some of the motors that powered record earnings this decade
-- leverage, off-balance-sheet investments, the business of repackaging
assets into bonds through securitization, and over- the-counter trading of
credit derivatives. Without them, it will be difficult to generate growth.
There are
solutions on the drawing board, but they will be tough medicine for banks to
swallow and lead to substantially lower profits. In a June 27 Financial Times editorial by
Gillian Tett ("Swiss look to leverage ratios in quest to go back to
basics") she observes, "the Swiss National Bank urged the country's
banking regulator to change the rules it imposes on banks, partly in reaction
to the UBS shock. And this initiative is worth watching closely since it puts
Zurich in the unusual position of blazing a
trail that others might follow, most notably in America." In an effort to
restore adequate methods to judge capital adequacy Tett reports that
"what the SNB now wants to see is a ‘back to basics' campaign in
the form of a bank ‘leverage ratio'. This would essentially require
banks to keep core capital at a predetermined percentage of the total balance
sheet (likely to be about 4 or 5 per cent) - in addition to meeting the Basel metrics.
Unsurprisingly, the banks loathe this idea since it would probably force them
to cut their balance sheets."
A more heavy-handed
Fed and Congress may impose further regulations and restrictions that will
shackle the sector for years. In a MarketWatch article, "Brokers threatened by run on shadow banking system,"
Alistair Barr presents the case for a "Super Fed:'
Next year,
Congress likely will pass legislation forcing big brokerage firms to be
regulated fully by the Fed as financial holding companies, Brad Hintz, a
securities analyst at Bernstein Research and former chief financial officer
of Lehman, said. Legislators will probably also call for tighter limits on
the leverage and trading risk taken on by large brokers, while demanding more
conservative funding and liquidity policies, he added. Restrictions on these
firms' forays into venture capital, private equity, real estate, commodities
and potentially hedge funds may also follow too, Hintz warned. This may
undermine the source of much of the surging profit generated by big brokerage
firms in recent years. A newly empowered "super Fed" will likely
encourage these firms to arrange longer-term, more secure sources of
borrowing and even promote the development of deposit bases, just like
commercial and retail banks, the analyst explained. This will make borrowing
more expensive for brokerage firms, undermining the profitability of
businesses that require a lot of capital, such as fixed income, institutional
equities, commodities and prime brokerage, Hintz said.
We simply got
carried away with finance and easy money. Companies came to rely on
generating more profits from the lending and finance arms of their businesses
than on sales of their actual products and services. The best physicians,
scientists, and engineers were being scoffed up by hedge funds for their
expertise. And they could pay them a whole lot more than they would have
otherwise earned, even being at the top of their professions. There was a
surplus of students pursuing degrees in financial engineering and a dearth of
students majoring in petroleum and metallurgical engineering. Is it any
wonder we are in such a mess? In an April 28th Wall Street Journal titled,
"Has the Financial
Industry's Heyday Come and Gone?" Justin
Lahart quotes one chief investment officer who cogently points out, "The
role of finance in the economy is going to come down significantly in coming
years...From a societal standpoint we got carried away with finance."
Later in the
article Lahart draws on the expertise of NYU economist Thomas Philippon
"who argues that the surge in financial activity that began in 2002
created an employment bubble that is now bursting. His model suggests total
employment in finance and insurance has to fall to 6.3 million to get back to
historical norms. The means losing an additional 700,000 jobs in the
sector." Goldman Sachs and Citigroup's recent announcements of laying
off 10% of their workforce is likely a mere harbinger of what is to come. In Manhattan it is
generally agreed that the financial industry drives the economy and that for
every job lost in the industry results in three other jobs being lost. They
are going to become increasingly reliant on foreigners to prop them up. This
is one group who won't be rooting for the US dollar to rally any time soon.
Perhaps the
most worrying aspect of seeing light at the end of the tunnel for an improved
leaner and meaner industry is the fact that we aren't out of the woods yet.
With stock market indexes plummeting to new mutli-year lows and warnings from
highly prescient analysts like Meredith Whitney of Oppenheimer --"...
[I] believe that what lies ahead will be worse than what is behind us...after
years of inherently flawed underwriting, banks face the worst yet of the
credit crisis - over $170 billion in write-downs and charge-offs from
consumer loans" - we might be better served bracing for more fallout
than trying to predict what the turnaround will look like.
There will be
an industry rebirth; it is just going to take longer than most people expect.
And when it does occur, look for many of much of the industry to migrate to
where the world's wealth and centers of commerce have been migrating for the
past decade-to Asia and China.
A McKinsey Global Institute study poses that the US might have already lost
its financial leadership due in part to the recent credit turmoil. While the
study (written last year) lists Europe as assuming the mantle of leadership,
it also mentions that the Chinese market is gaining as a result of booming
exports and new wealth creation. In Tomorrow's Gold: Asia's Age of Discovery,
written by Marc Faber in 2002, he contends that the shift in the movement of
international capital flows will continue eastward and that "No other
country in the world has ever developed, in such a short space of time, such
a large financial market as China."
A report on the
top 75 centers of commerce commissioned by MasterCard just included Shanghai
in its "Top 25" with an eight-position jump, the largest of any
city in the top 25. According to a Financial Times article, it
earned its new place for being "[a]mong the world's most populous and
fastest-growing cities...bolstered by its economic stability, its legal and
political framework, and increased quality of life and China's booming
economy." There are no assurances that Shanghai will be the top
financial hub in China, never mind the rest of the world. The Chinese smell
the opportunity to knock Wall Street off of its perch and three cities within
China itself are vying to grab the mantle-Shanghai, Beijing and Shenzhen. All
three cities have a legitimate case to make. My money is still on Shanghai
but don't count the other two out.
Just last week
Hong Kong announced plans to create its own commodities exchange. The next
article I write might be, "Escape from Chicago." The Wall Street
Journal informs that:
The new Hong
Kong Mercantile Exchange, set to open as soon as the first quarter of next
year, will sell U.S. dollar-denominated contracts for delivery of fuel oil to
mainland China, where it is often used as a power source. From there, Hong
Kong hopes to expand into commodities that could range from soybeans to iron
ore. The exchange fits into the larger designs of Hong Kong officials, who
are looking to bolster the Chinese special administrative region's standing
as a regional finance hub. It faces a growing challenge from China's
mainland, which has grown in importance as a new investor class arises and as
Western companies grow more comfortable doing business there.
And if you
think US hedge funds are immune from this fallout and transition, then you should
think again. A June 26 Bloomberg article titled, "Asia to Create
Thousands of Hedge Fund Jobs," tells
us that Asia's expanding hedge fund industry will probably create tens of
thousands of jobs in the next five years, even as investment bank recruitment
dries up after the US subprime mortgage collapse." The same story quotes
another analyst who notes, "This [Asia] is still very much an active
market and much more bullish than we are seeing in Europe and the US."
London and New
York will likely remain major centers for financial markets and industry
employment for the rest of the century. And Shanghai and the rest of Asia are
not likely to escape unscathed by further worldwide financial market
meltdowns. Further, China is probably a decade away from making the
institutional reforms necessary to make their financial sector resilient
enough to compete with New York and London. Nevertheless, I think most are
going to be astounded at the pace and depth to which financial market
activity flows from the West to the East. Many of these industry participants
will be following famed US hedge fund manager Jim Rogers out of New York and
into Asia, and eventually into China.
Excerpted from
the 6/30/08 Global MegaTrends Portofolio's Newsletter:
To view the
full newsletter and gain access to Kurt's market-crushing Global MegaTrends
Portfolio, click here.
Kurt Kasun
www.greenfaucet.com
A
contributing writer to GreenFaucet.com, Kurt
Kasun writes a high-end investment timing service, GlobalMacro, which is
focused on identifying opportunities that produce returns in excess of market
with reasonable risk. He is strategically located in Washington, D.C.,
a key to maintaining contacts and relationships which help Kurt understand
global policy and economic factors as they emerge. His investment approach
has always been macro in nature largely due to his undergraduate studies at
the U.S. Military Academy
at West Point (B. S. National Security, Public Affairs, 1989) and his
graduate studies at George
Mason University
(M.A. International Commerce and Policy, 2006).
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