The past 10 days have been “the most dramatic in Wall Street’s 216-year history” seeing Lehman Brothers collapse, AIG fall into critical distress, and the US Federal Reserve creating a c. US$1 Trillion rescue plan to “save the world”.
While many investors were caught in this crisis, the leading economists in the world saw it coming. In this article, we talk exclusively to Kenneth Murray who is Chairman & Executive Director of Blue Planet Investment Management, and a renowned banking economist about the factors which caused the crunch, whether banks have bottomed out, the future of global banking, and whether it’s the right time to invest in banks.
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September 24th 2008 – Vikas Shah
In early 2008, if a journalist had written that Lehman brothers would fall into Chapter 11, AIG would become critically distressed, and the federal reserve would be forced to create a c. US$1 Trillion rescue plan to, "save the world", they [journalist] would have openly been ridiculed for making such 'far fetched' predictions (with the same vigour as scholars who argued the earth were round were ridiculed during the Classical period).
Today, only eight months later, we are confronted with a situation where market observers are calling September 2008, "the most dramatic in Wall Street's 216-year history".
While many investors were caught in this crisis, the leading economists in the world saw it coming.
In this article, we talk to Kenneth Murray who is Chairman & Executive Director of Blue Planet Investment Management, and a renowned banking economist.
In a privileged question and answer session, we discuss the mechanisms which caused the ‘credit crunch’, look at the future of banking in the UK, US and Internationally, and understand where to invest in Banking.
Mr. Murray studied economics and computer science at Stirling University, and with an interest in financial markets he joined the city as a banking analyst. Mr. Murray quickly ascended the career ladder, becoming a Director of Fulton Prebon International Limited, one of the World's largest money brokers (which had operations in London, New York, San Francisco, Tokyo, Hong Kong, Singapore, Sydney, Bahrain, Luxembourg and many other financial markets). In 1990, he founded the Bank of Edinburgh Group plc, with the aim of rationalising the building society sector. His bank was the first to purchase a building society (The Heart of England Building Society, 1992, with assets of £1 billion). In 1994, following the sale of his bank, Kenneth Murray created Blue Planet Investment Management, with the aim of becoming, “the best manager of financial stocks in the world”.
“For me” says Mr. Murray, “Economics is a greatly rewarding intellectual challenge, like a game of chess, where along with the satisfaction of winning, you have a constant desire to play the game better”.
Q: What fundamentally went wrong in the markets, and what do you think to those who are “calling bottom” on the markets, and betting on an upside?
We predicted this back in April 2007, and the first question you have to ask yourself is “what gave rise to the increased activity in banking in the period from 2003-2007”. This is a fundamental question. The main driver of this growth was the rise in personal consumption, which has a number of elements. We can only consume at the rate of the growth of incomes, and we saw that consumption was exceeding incomes. The savings ratio reduced from a historic 5% to currently less that 1%, and finally people were “borrowing to spend” (which increases consumption). Not only were people borrowing, but they were borrowing multiples of their earnings, so the level of consumption dramatically increased. As inflation fell, interest rates followed, and people could therefore leverage (borrow) more, assuming their primacy asset (property) would hold them in retirement.
What we are seeing is a correction. As people ‘maxed out’ their borrowing curve shifted upwards. People can borrow and spend, but ultimately, they have to pay it back, and that’s when the consumption curve falls. The increase in demand is seen as money is spent, but then income is set aside to cover the borrowing, and hence the consumption curve falls. This is a particularly strong phenomenon in over leveraged economies such as UK, USA and Denmark. Elsewhere in the world such as India and Russia, personal debt as a proportion of GDP is much lower.
In terms of those who say the market is bottoming out, the first thing to look at is the track record of the people. To use an analogy I learnt at University, it doesn’t matter how nice or unpleasant they are, it’s the results that count. The overwhelming majority of analysts failed to see “what was coming”, this, in my eyes, discredits them. You are very unlikely, if you didn’t see it coming, to understand what happened.
Q: So where is the value in banks?
There will be virtually no growth for UK/US banks going forward. They may be able to exact efficiencies, and shifting bad debts to governments will de-risk the sector and re-rate stocks, but the economies will still slow down in the UK/US but by a smaller rate than a few months ago. This may create the question, “if we normalise risk, where’s the value?” In my opinion the earnings growth is in the developing market which is underleveraged, and as has budget surpluses, these are the regions where the top-lines will grow.
In terms of the US and UK, we will certainly get a rally of banking stocks due to the de-risking and unwinding of short positions, but this will also initiate mergers in both countries. Goldman Sachs and Morgan Stanley will certainly go out to buy retail banks, and we must watch out for the ‘clever’ banks such as HSBC who have steered through the markets very intelligently meaning their relative positions have shot up. Once we see this kind of activity, the rest of the market will typically head back ‘in the water’.
In our own funds, we allocate similar methodologies to our investments. Banks are a proxy for economies, and we look for well run economies, sector growth, under-penetrated economies, and solid leadership.
That strategy, though, has not worked well in the past 12 months, as the economic sentiment is non-discriminatory. URSA bank in Russia has profits up 200% last year, 60% up this year, but the share price has dropped 80% even though they have not put a foot wrong. Consider even their economy (ignoring politics) which shows the third largest foreign exchange reserves in the world, abundance of land and natural resources (mostly unexplored and unexploited), trade balance and budget surpluses, and over 7% GDP growth. This represents a perfect balance sheet, versus the UK and USA which read more like an IOU.
Q: What are your aims as a fund manager within these turbulent markets? and how do you make salient financial decisions in a market which is behaving, as Bob Diamond from Barclays said, "without a rulebook"?
We are not in a market “without a rule-book”. It is worrying when people say that.
This is economics. There are, in economies, times when madmen take over who understand nothing about anything but operate on emotion. The laws of economics always come into play.
Where we are at the moment is the tail end of a banking crisis. The reason it’s a tail end is because the practices that gave rise to bad debts stopped a year ago. We are now getting bad debts through the system, and after that, “that’s it”. We will be left with ultra conservative banks who are risk averse and trade with wider margins. Oligopolies such as HBOS/Lloyds are inevitable, and create a level of control of markets which allow them to withstand bad debts, and the power to extract returns from economies.
We are near the bottom, but people are still feeling worried, as most do not understand markets enough to make intelligent decisions on economic propositions. Emerging banks can be bought on P/E ratios of between 2-5, this is incredible, as these banks earnings are increasing 20-150% per year with sound balance sheets. In the case of India, its reserve bank imposes incredibly strict controls (high cash reserve ratios) which give very low risk. While both these countries are bothered by inflation (particularly India), in essence, they carry less risk than the west, but are considerably cheaper. Share prices in these regions have fallen more than the badly managed western banks.
Q: Do you think that increasing regulatory intervention is a positive thing for markets? And has banking failed the principle of ‘free markets’?
There are many factors at play here, but the management of monetary policy at the federal reserve (Greenspan) has played a big role. Greenspan flooded the market with cheap money (1% interest). When banks have little money to lend, they are selective who they lend to, and they want a good rate of return. When banks are awash with money, they soon exhaust “good” proposals, and engage in riskier activities, with poor credit. The more excess liquidity, the greater the bad debts. This is an inevitable consequence of bad management of money supply by central banks. Cheap money causes problems.
Banks and their actions are to blame also. Banks do not have to borrow money from central reserve but they chose to do so. In the same way, they did not have to lend this excess capital, but they chose to do so. This was a fundamental failing of bank boards, and an issue which needs to be addressed. The ultimate regulator of a market is not government (FSA/SEC) but is the bank boards. Strong management is essential, and banks need to stop hiring the “great and good” (ex PLC directors from unrelated industries who know nothing about banking, risk, and economic cycles) and instead look at bankers with track record, and an understanding of systemic risk. This has to be addressed before any rules changes are made at a policy level.
Q: Will the unwinding of risky derivatives and the absence of complex products from their activities see bank shares 'under perform' against their historic figures?
The reason for underperforming is there is no potential for earnings growth. Banking is shrouded in mystery, but a simple example is….
If you consider a country where 5% own mobile phones, and the rest are rapidly accumulating wealth and want those products, is that not a better place to be?
The same is true of banking services. In western markets, everyone has loans and too many loans, that is why everyone is defaulting. In Russia and India, there is huge growth opportunity, but much less risk. These aggregate numbers are very important. If Loans/GDP is c 7% it is like saying that a person on £100,000 has £1,000 of borrowings. In western economies if you earn £100,000 you are likely to have £200,000 in borrowings. This is, therefore, a key indicator of risk. The West will not perform too well (in general) but the ones which will are the investment banks which, as confidence returns in economies, will create more banking volume in mergers and acquisitions.
The greatest risk going forward is the unwillingness of banks to supply credit (which is much diminished as it’s simply not prudent to lend).
Q: Many analysts and traders favour 'technical analysis' as a method to deliver trading signals and trend information. Do you think in current markets, technical trading still provides a reliable strategy?
I don’t think that it [technical analysis] has ever proved reliable. If you consider the mathematical principle of VaR (In economics and finance, Value at Risk (VaR) is the maximum loss not exceeded with a given probability defined as the confidence level, over a given period of time) which, as any mathematician will tell you, is basing your risk analysis for what will happen in the future, on what has happened in the past. Ultimately, this is a flawed hypothesis. If I were to walk towards the end of a cliff, and after 98 steps I fell down a six foot hole, VaR would tell me that on average, every 98 steps I take, I will fall down a six foot hole (even though I am only two steps away from the edge of the cliff). Regulators and analysts love this kind of mathematical analysis because it looks like “good science” and gives the air of being useful. If you are a real mathematician or economist, you will know that it is fundamentally flawed, the unpredictable will always happen, that is the nature of things. VaR tells you the risk of an activity is X, and when an unpredicted event happens, that goes out of the window.
Einstein once said, “Knowledge is great, but imagination is better”. If you are backward looking number cruncher, you will never be great. The great economists are those with the vision to understand the market, demand, supply and how “this” set of things will result in “that” in twelve months time. It is the reason I enjoy being in the company of intellectual people where you can query “why do you hold that view?” without being given the response of simply “I have a feeling”.
If you look at the current downturn, it was predictable. The adjustment that is now taking place is a result of the reduced ability to borrow and spend.
So many analysts don’t think out of the box, and are simply “regurgitation machines” and they do not look at the macro position. The same is true of many economists. It is astounding that they don’t see problems, and when they occur, they are miles behind and incapable of understanding a resolution.
Q: Do you think it’s a good time to ‘buy in’ to banks?
We are much nearer the right level to buy banks in the right part of the world. If you can take a 2-5 year view, or even better, a 10 year view you will make huge returns. As Warren Buffet says, “buy good stocks and let them make the money for you”.
From this shake up will come immense opportunities, some banks and assets have been massively over-sold and when normality is returning, this will create growth. You have to have the courage to get involved at the bottom to make serious money and this courage comes from understanding what you’re doing.
A good analogy is to think of economics as an oil tanker, when in motion, its course is dealt. When banking was flooded with cheap money, this flooded the market, and created actions and consequences which were predictable. Even the development of economies is predictable, and is part of human nature, with very few new behaviours. Once the system is de-risked, people will then look rationally at individual banks asking “who is this bank?”, “what is the growth potential?”, “what is the ratio of deposits to loans?”. All of these questions along with analysis of penetration of banking services, point to emerging economies and against most western banks.
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We are seeing in the media, many articles calling the “bottom of the market”. Mark Arbeter (technical strategist at Standard & Poors) was even quoted as saying, “On three straight days a third of the stocks on the New York Stock Exchange hit 52-week lows, the first time that has happened in almost 35 years. We think evidence of a climax bottom last week were overwhelming”.
Mr. Murray’s analysis shows how the current ‘downturn’ is the expected and predictable response of underlying economic forces, and shows the failings of not just policy makers, but the bank management themselves who act as the true ‘regulators’ of the market. It is these economic forces and principles which could have predicted the failures, and can provide insights into the solution and future, historical analysis and models while interesting, simply cannot take the unknown and the ‘macro’ into account.
Our economy was at the brink of correction, as our insatiable demand peaked with absolute saturation of available space.
It was Doug Horton who summarised this perfectly in his quote, “First rule of Economics 101: our desires are insatiable. Second rule: we can stomach only three Big Macs at a time.”
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Blue Planet in their own words, "Blue Planet Investment Management Ltd is a Maltese based investment management company which specialises in managing investments in financial companies. Our corporate philosophy is that consistent out-performance is more likely to be achieved by specialisation than it is from the generalist approach, which currently prevails across most of the fund management industry."
You can find out more about their activities online at: www.blueplanet.eu
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