How bad things get is an unknown unknownEmail Print Normal font...

How bad things get is an unknown unknown
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Malcolm Maiden
August 18, 2007

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"REPORTS that say that something hasn't happened are always interesting to me," then US Defence Secretary Donald Rumsfeld said in 2002, "because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don't know we don't know."

Rumsfeld was lampooned mercilessly for that comment, but those exposed to this week's market gyrations have reason to revisit it now. As investors learn more about the nature of the correction, the considerable dimensions of the unknown are being drawn more clearly, and fears that something unanticipated is in the shadows continue to lurk.

It's officially a 10 per cent correction, we know that much, and we know too that the downshift has opened up value — but so far, only in a selective way. There have been some tantalising shifts: Asset engineers Macquarie, Allco Finance and Babc ock & Brown, for example, are 33.3 per cent, 42.8 per cent and 45.7 per cent respectively below their highs.

But the Australian sharemarket does not yet offer across-the-board value, because it got ahead of itself before the correction hit.

In the first quarter of the year, Australian industrial company share prices became as much as 13 per cent more expensive than the basket of global stocks that make up the Morgan Stanley Capital International index. They are cheaper now but are still at a 7 per cent premium to the MSCI, which has also devalued. Australian industrial companies as a group are selling for just under 14 times their expected earnings in the next year, which is cheaper than their peak in the first quarter of 15.8 times, but really only back to average levels over the past 15 years.

We know too that the reduced values are supported by predictions that earnings will continue to expand at a rate of about 10 per cent a year in Australia and around the world, and something like that will be achieved in the current June-year reporting period.

But the big known unknown is what happens after that. The profit growth forecasts ahead of the slump assumed that China would maintain its 10 per cent-plus growth rate and propel world economic growth to about 5 per cent this year, enough to carry the US as its housing market downturn reduced 2007 economic growth to about 2 per cent. It is less clear at the end of this week, than it was at the beginning, that this is achievable.

It's true that the market downturn hasn't undermined economic growth so far but that's a bit like falling off a cliff and remarking halfway down "so far, so good". At the end of this week, more people are saying that a shock of this magnitude probably can't occur in a vacuum. Commonwealth Bank chief executive Ralph Norris this week stated the obvious — a credit squeeze is the source of the problem and, when credit is tight, interest rates tend to rise.

World central banks have been tipping liquidity into the system to offset the de facto monetary tightening but, even as Reserve Bank governor Glenn Stevens was maintaining that growth outside the US was on track yesterday, fears that the correction was spreading into the real economy were turning up in the markets; in weak metals prices and growing price pressure on mining shares, for example.

Oil, gold and other metal prices all fell sharply ahead of yesterday's market opening, with copper falling 7.8 per cent to be 24 per cent below its May high. Nickel fell by 5.3 per cent, and has halved in price since May, and the Bloomberg wire reported yesterday that the world's most closely watched commodity price index, the CRB, posted its biggest slide since 1958 on Thursday night. The resources stocks here were predictably fragile.

In part, the selling is being forced by the liquidity drought: hedge funds, investment banks and other investors who began directly buying metals about two years ago as the boom intensified are now selling liquid assets including shares and metals assets to raise cash.

But the sell-down, which centred on Japan and the Asian markets yesterday, also reflects the fact that the downturn is increasingly being seen not just as a market phenomenon, but as something that is likely to hurt economic growth, in the US first, but also in Europe, Japan, China and the rest of Asia including Australia, as US consumer demand slows, and exports into the US decline.

One thing that is known now is that the boilerplate disclaimer issued by many groups at the beginning the sell-down — "no direct exposure to the US subprime market" is meaningless. The real question, as RAMS demonstrated in this market when it announced that it was no longer able to roll over short-term commercial paper in the US, is not whether there is exposure to the subprime meltdown, but whether there is exposure to the various markets subprime has infected.

It is also known that the markets face a large resettlement task. Groups like RAMS will be seeking to refinance short-term debts, and about $US300 billion of pre-correction takeover money must also be syndicated, parked on the balance sheets of the banks that agreed to back the takeovers, or withdrawn, with accompanying break-fee penalties. The size of the job won't be known until at least next month, when the northern hemisphere holidays are over.

Donald Rumsfeld's shadowy unknown unknowns are undefined, obviously, but they have surfaced before. Two years after the tech boom crashed in 2000, investors learned that they had not only overvalued companies, but done so sometimes on the basis of lies about their financial strength and profitability. The market's skittishness this week in part reflects a primal fear that a financial Enron is out there somewhere, beneath the already stormy surface.