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Unknown unknowns

What the markets round the world are facing these days is what Rumsfeld would call Unknown Unknowns. No market — except the commodity market — is immune.

So what is this sub prime noise all about. James Kunstler summed it up very nicely in these words "What you had was a whole industry that surrendered the standards and norms that brought it into being and enabled it to function in the first place. Mortgage lenders stopped requiring house-buyers to qualify for loans; bankers stopped caring what stood behind the paper they issued; dubious loans were bundled and resold like barrels of rotten anchovies — in such numbers that no individual stinking minnow would stand out — and the barrels were traded up the line, leveraged, hedged, fudged, fobbed, and fiddled until, abracadabra, they were transformed into so many Tribeca lofts, Hampton villas, Piaget wristwatches, million-dollar birthday parties, and Gulfstream jets."

The first logical question that comes to mind is : how big is this sub prime market? My research tells me that it is about 12 per cent of the US mortgage market. Big no doubt, but not big enough to cause a major problem.

Let us now look at the sequence of events. The Fed, just a few days ago, felt that the credit markets were still functioning adequately, if somewhat creakily, and did not believe there was a crisis at hand. Bankers and news channels have been fretting about some "evaporation of liquidity" as some of thes sub prime debts were becoming illiquid or "difficult to price". Although an increasing number of banks were owning up to sub prime woes, the Fed felt that there was nothing to suggest that this posed any sort of systemic risk to the financial system. The markets stabilised and the stock markets rejoiced with 2 to 3 per cent gains world wide this past on Wednesday.

Two things happened on Thursday before US markets opened. BNP announced it was suspending redemptions on three of its funds which had sub prime exposure and the markets talked about BNP being just the tip of the ice berg. Overnight rates leapt up to 4.7 per cent against ECB's target rate of 4 per cent. The ECB moved in to inject liquidity. They pumped in $ 130 billion. The rates came down to 4.1 per cent. 49 banks stepped in to take this $ 130 billion injected by the ECB. This intervention is, according to Forbes, far short of the liquidity pumped in even in the aftermath of 9/11.

Friday was not much better. Lots of liquidity was injected by Central Banks round the world (including the far eastern central banks) but still the stock markets close down a fair bit. So what do I think. I do not think stock valuations round the world are ahead of themselves. I think there is plenty of value round the world (especially after these recent corrections). My thoughts are: I believe that the secular growth story as far as emerging markets are concerned remains strong. With the Chinese authorities trying hard to restrain export growth, China and emerging markets can and will withstand some slowing in the US economy. The US economy will successfully soft land and will not go into recession. Remember that emerging economies are running large trade surpluses, have low inflation and their companies are sitting on some of the largest net cash balances in a generation. They trade at around 12 times 2008 earnings and at about 2 times book. Sectors like resources, infrastructure, telecoms and healthcare in emerging markets should be particularly attractive. Selective special situation exposure to low cost producers of severely supply constrained commodities with huge productioin ramp-ups in coming years will be particularly well shielded from any shocks like that we are currently witnessing. That does not mean you invest in every private equity fund offering that comes your way. A combination of further dollar weakness and increasing export competitiveness will see the US economy through in the coming five or six years (I will elaborate on this theme in a future article). Net net, I fully expect this crisis to blow over in the coming weeks and stock markets to regain their end June/early July heights well before Christmas 07. Stay invested but choose your fund managers carefully.