Crisis means opportunity.
“Luck is the sense to recognize an opportunity and the ability to take advantage of it.” – Samuel Goldwyn.
Imagine you have a mortgage and the payments stretch your paycheque to the limit. Your mortgage is now up for renewal at much higher rates and you just don’t have the extra several hundred dollars a month it takes to make the payments. Not making mortgage payments means delinquency, default and foreclosure. That’s how many US homeowners spent their summer vacation.
Now multiply by $650 billion.
According to BCA Research, $650 billion of adjustable rate mortgages are due to reset at higher interest rates over the next 16 months. Many will default.
This is bad news because housing has moved “from a significant contributor to growth to a major drag on the economy” according to the Center for Housing Studies at Harvard. Further, “the potential impact of a housing slowdown on consumer spending has yet to hit”.
A squeezed homeowner has less discretionary spending room. (When your outgo exceeds your income, your upkeep is your downfall). This is bad news because consumer spending accounts for nearly 2/3 of all US economic activity.
It gets worse.
After 5 years of strong earnings, corporate balance sheets are in good shape. Right? Wrong. Corporations have added debt to finance buyouts, takeovers and share buybacks. Credit quality has deteriorated. Standard & Poor’s says that over 50% of all corporate debt is speculative grade – up from 40% ten years ago.
So we have an exhausted consumer, leveraged corporations, slower economic growth, higher interest rates, tighter credit standards and inflation. One can expect to see more ‘Made in America’ stock and bond market volatility. July and August was the beginning.
This bad news is good news because crisis means opportunity (eventually).
Crisis and volatility mean bargains and more reasonable valuations for the long term investor. This is good because valuations were (are still?) stretched.
A beat up US will (soon) be a buy-low opportunity. The US dollar is at an all time low against the Euro (and a 30 year low against the Loonie – hint!). According to the OECD, the US dollar is undervalued by 15%. Investors can (soon) buy cheap assets especially in the US export sectors.
South East Asia is expected grow more than twice as fast as the US. As these markets grow they develop their own domestic demand, de-couple and become buffered from a US slowdown. This trend will continue as 10 Asian countries representing ½ billion people will form a Free-Trade area by 2015. Asia is a diversification opportunity less correlated to the US housing crisis. (Not immune, but not as tied).
Other emerging economies too are stronger, more stable, less dependent on US growth and, again, not as linked to the US housing crisis. Many are now creditors instead of debtors and balance sheets are in much better shape.
And China and India have about 2.4 billion people that must be fed, educated and employed regardless of any crisis.
These non-correlated diversification opportunities are the holy grail of portfolio management.
Originally published in the Business Thompson Okanagan news, October 2007.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.