Happy Days Are (Not) Here Again (Yet)

I recently attended an excellent seminar held by State Street Global Advisors and Morningstar. Although the meeting focused on building portfolios with exchange traded funds (ETF’s), the highlight of the afternoon was a presentation on the current state of the global markets.

The speaker, Shawn Johnson, who heads State Street’s investment committee, made it pretty clear that the financial world is not back to normal. The recent blip in the stock markets notwithstanding, capital flows and business conditions are far from normal. But for the federal money tap, credit markets would still be largely frozen instead of only somewhat frozen.

He gave as an example the case of American Express. Amex’s main credit card business model is one in which merchants pay them 4% of revenue charged on most Amex cards.  Generally, their cardholders are required to pay their bills off monthly, so on average American Express makes a 20-day loan of the funds charged.  American Express pays the vendor $0.96 for every dollar charged and 20 days later Amex is paid a dollar by the cardholder.  The model is simple and lucrative, but American Express must keep a lot of cash on hand to pay merchants.  To reduce its cash flow needs, Amex used to sell its receivables to other entities, effectively taking its payoff margin down from 4% to 2%. But even 2% is an attractive payback for a 20-day loan.

The problem is that starting late last year, American Express began having trouble finding parties willing to buy its receivables as the wheels fell off the credit market.  Uncertainty has either made former buyers skittish, or else they simply don’t have the cash.  In order to keep the business going, American Express has become a bank holding company regulated by the Federal Reserve.  The move allows Amex to borrow Fed funds.

As the Wall Street Journal recently reported, even motorcycle manufacturer Harley-Davidson is getting TALF funds.

Johnson’s prognosis for the recovery was not very pretty – the only way for markets to be restored to normal, he said, is for some companies to fail. Bad debts need to be recognized as such, so that order can be restored to the credit markets.  When Johnson was done, the fellow sitting next to me turned to a friend and said, “now I’m depressed!”

Nobody likes to see companies fail, but things need to get worse before they can get better. Yet at the moment, investors don’t seem to understand this. Demand for secondary stock sales (new sales of stock from existing companies) is the highest that it’s been since 2000.  Investment-grade bonds are being sold at the highest levels ever recorded.

Yet overall, private and public debt levels are at all-time highs relative to GDP.  For debt to return to manageable levels, a good chunk of the debts must either be paid off or eliminated through bankruptcy.  The Fed and Treasury can prop things up for a while, but their ability to borrow at record low rates can only last for so long.  Eventually, our creditors will start to worry about our national creditworthiness, and when that happens they will either stop lending or will demand rates of return that are too high for us to bear.  Some of our largest creditors have begun politely hinting that they’re uncomfortable: this week’s Barron’s reported that China has called for a new currency to replace the US dollar’s role as the global reserve currency.  Japan recently suggested that the U.S. Treasury should start issuing some of its bonds in yen (just in case the dollar starts to fall versus the yen, perhaps?)

What does this mean for small investors?

I don’t think it means that you should abandon a diversified portfolio for long-term goals; it does mean that you need to reconsider the amount that you have allocated to the riskiest asset classes if you haven’t done so already.  It definitely means that you need to revisit your personal risk management plans.  Emergency fund cushions need to be skewed towards the worst-case scenario for your household; if you have a three-month emergency fund, consider building it up to five months.  Review your own debt levels; if you can take advantage of refinancing at lower rates, consider doing so.  Keep an eye on your employer’s business prospects and keep your resume updated.  If you were planning to retire this year, unless you’re in an extraordinarily strong financial position, try to keep working for at least another year.

About the author

Thomas Fisher, CFP®

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