Investors’ short memory is worrying

Granted, the sub-prime crisis has passed. But the US economy has other major problems. So it’s advisable to be prudent

By WONG SUI JAU

WHAT a difference two months makes. In mid-August, the sub-prime loans scare had just rocked markets around the world, causing them to fall for two weeks. The air was heavy with gloom. But now, it seems as if the sub-prime problem never happened. Many markets are back to their pre-crash levels and, indeed, some – including the US market as represented by the S&P 500 index – have recently hit record highs. As the accompanying table shows, many Asian markets have done very well from the start of the year up to end-September. There is reason for much cheer among investors.

While I was one of those urging calm at the time the sub-prime issue blew up, I find the short memory of many investors worrying. Before the sub-prime issue flared in the US, there was hardly anything to worry about; Asian economies were growing strongly and the rest of the world was doing decently too.

But in the aftermath of the sub-prime crash, some things are now different. Investors need to pay close attention to these developments – not just focus on the happy reality of rising markets. The most significant thing is that the US economy has turned. As recently as the second quarter, US GDP was still accelerating in terms of growth, growing at an annualised rate of 3.8 per cent in Q2, compared with an annualised 0.6 per cent in Q1.

However, the sub-prime issue has exposed weaknesses in the US economy that are not going to go away, rising markets notwithstanding. First, the US property cycle is on a clear downward trend – and this is accelerating rather than slowing. The supply of homes has almost doubled since end-December 2005. A large number of unsold homes will put further downward pressure on prices. The sub-prime fright has also made investors much more cautious about entering an already falling market. After all, if home prices are dropping, there is no hurry to buy, because it is better to wait for prices to fall further. Thus, we may see an even steeper decline in US home prices going forward (see chart).

Second, the woes in the US property market will affect many American consumers. Americans have been consuming ever more each year, and accordingly, their debt levels have risen. The ratio of household debt to disposable income was at a high of 2.29 in March 2007, compared with 0.82 in December 1990. This means that for every dollar of income earned, the average US household has $2.30 of debt.

Previously, the rising housing market enabled Americans to take out reverse mortgages and get money from the houses they stayed in. But with prices now falling, this will dry up. Some households may even run into problems paying off their home loans. Certainly, this will affect household spending going forward. Any weakness in consumer spending – which underpins so much of what drives the US economy – will put a question mark over growth next year.

Continued volatility

Third, the US continues to do things like reduce interest rates and deflate the dollar. This may work in the short term. But over the long term, it does not solve the fundamental problem that the US economy faces – which is that it spends far more than what it generates in income, resulting in its huge twin deficits. For now, since it is the sole superpower and with the US dollar still the most important and most used currency in the world, cutting interest rates and allowing the dollar to weaken may work in the short term. But eventually the US will have to face up to its problems – and when it does, its economy is likely to be affected. A recession is quite possible.

So while the recent recovery in markets has brought much cheer and relief to investors. I would urge people not to get too greedy and overexpose themselves to risk. While we believe that, ultimately, Asian economies with their many drivers will continue to grow even amid a US recession, their growth will ultimately be affected to some extent. And certainly, markets will continue to be volatile.

As data is released in the coming months, we expect that some of it relating to the US economy will not be rosy.

Companies at the epicentre of the sub-prime loans issue have had to close down entire divisions, and many banks are expected to report large provisions for loans made, which will certainly affect their earnings. For example, just recently, Bank of America, JP Morgan Chase & Co and Wachovia Corp posted profit declines as they wrote down more than US$3.4 billion. They will not be the last to report earnings hits.

In the midst of record-breaking markets, investors may have forgotten just how bleak the situation seemed just a couple of months ago. But they must be conscious of the risks they are taking in their portfolios. Try to stay diversified and not overly exposed to any particular sector or area, no matter how attractive it seems. With many investors already sitting on profits this year, it would be advisable to be prudent at this stage. Don’t let short memories and greed lead to overly aggressive risk-taking.

 

Source: Business Times 17 Oct 07

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