Having initially opposed such drastic measures because of fears that they would remove all incentives for banks to properly manage their risks, authorities in a wide range of countries, including the UK, Germany, France and the US, have this week committed more than $2 trillion to purchase shares in private banks. By injecting necessary capital into the banks, the governments hope to shore up their balance sheets and get them to start lending again.
ôIt is now a question of survival and that means the moral high-ground takes second place,ö says Markus Rosgen, head of equity strategy for Asia-Pacific at Citi, as an explanation of why the authorities are now willing to take a more hands-on approach. ôThe central banks basically realised at the end of last week that if this goes on for another week, we will be in a great depression.ö
The rally in global equities over the past two days suggests that investors agree that this drastic action was needed and that the move may finally give banks the confidence to lend to other financial institutions again û something that they have been unwilling to do as they worried about the risk of their counterparties going under. The return to a more normal interbank market has been cited as a key criterion for getting investors to commit capital into equities again.
Stockmarkets across Asia, which finished last week at multi-year lows, jumped on the news as investors speculated that the bottom might have finally been reached. Hong KongÆs Hang Seng Index added 10.2% on Monday followed by a 3.2% gain yesterday, while in Japan, where markets were closed on Monday, the Nikkei 225 index rallied an unprecedented 14.2% yesterday. TuesdayÆs gains were supported by an equally rare 11% surge in the Dow Jones index over night.
ô[The marketÆs reaction] is a great relief that, having stood at the edge, we didnÆt go over,ö says Rosgen. ôThere is still a whole recession to go through and that recession is probably going to be quite painful, but while this isnÆt the end of the bear market, it is not going to be the end of the financial system either.ö
The Dow opened higher on Tuesday as well, and at one point, after the Bush administration announced that the US will follow Europe and inject capital directly into the countryÆs banks in return for equity stakes, it was up more than 400 points. Not surprisingly, though, given the lack of sustainable rallies over the past month, some investors chose to take profits on MondayÆs gains and by the end of the session, the benchmark index was down 0.8%.
Profit-taking aside, the turnaround may also have been a first sign that investors will now be ready to look beyond the financial crisis and turn their focus back to the real economy, which, as noted by Rosgen at Citi, looks set for a period of significantly slower growth û if not outright recession û and lower corporate earnings. And while there ought to be room for some near-term gains, few market watchers expect share prices to return to the levels they were at before the summer.
ôBeyond a short-term rebound, the road is likely to remain rough for a while as the deteriorating global growth outlook and efforts by households to reduce debt levels both weigh on profits,ö says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors.
This weekÆs stockmarket bounce û while impressive - also needs to be put into context. At TuesdayÆs close of 9,310 points, the Dow Jones index is still well below its levels from 12 months ago when it traded above 13,900 points and even two-and-a-half weeks ago it was still above 11,000. The Hang Seng index, which closed at 16,832 points yesterday, was trading above 25,000 as recently as early May and a year ago reached a record above 31,600 points. And the Nikkei, currently at 9,447 points, has fallen from above 12,000 since mid-September.
Also, trading volumes were still quite thin both on Monday and Tuesday, which suggests that many investors and asset managers are still on the sidelines.
That said, there is no question that the latest moves to prevent a systemic financial collapse have gotten an initial nod of approval from the market. And it is, perhaps a bit surprisingly, Europe rather than the US û and particularly British prime minister Gordon Brown û that has emerged as the strong party willing to take ownership of the banks as they provide capital. This will be costly for the taxpayers in the short-term, but may well see them make a profit once these equity stakes are re-privatised in a recovered market.
On Sunday, Brown together with the other EU leaders pledged to inject emergency capital into ailing banks in return for ownership, to individually guarantee bank refinancing until the end of next year, and to take other swift measures to encourage banks to lend to each other again. On Monday this was firmed up as Britain, Germany, France, the Netherlands, Spain, Portugal and Austria said they would commit $2.3 trillion to protect their banks û a number that dwarfed the $700 billion set aside in the US. The seven EU members also joined the US in saying they will provide unlimited short-term dollar credits to financial institutions.
On Tuesday, the UK government said it will be injecting ú37 billion ($64 billion) into the Royal Bank of Scotland, Lloyds TSB and HBOS, which is in the process of being acquired by Lloyds TSB, through the subscription of preference shares. The injections come with requirements to lend and caps on executive pay, signalling that this is not money for free.
Following the positive reaction in the markets to the EU plan, US Treasury secretary Henry Paulson followed suit yesterday with an announcement that $250 billion of the earlier approved $700 billion rescue package will be used to buy equity in US banks. The initial intention had been to use the money to buy mortgage-linked assets from the banks to help remove toxic assets off their balance sheets. As a first step, the government will inject $125 billion into nine major banks with the intention that they will use it to rebuild their reserves and resume lending to consumers and businesses û thus helping to promote economic growth.
Bank of New York Mellon became the first bank to take advantage of the programme, saying it will sell $3 billion worth of preferred shares to the Treasury. Other financial institutions initially participating, according to US media, include Goldman Sachs, Morgan Stanley, J.P. Morgan Chase, Bank of America, Citi, Wells Fargo and State Street.
While the reaction was initially positive, it remains to be seen whether the capital injections will have the desired effect on lending and on short-term money market rates. As of last night, three-month Libor was flat at 4.64% following a drop from 4.75% on Monday. The rate has jumped from 2.75% in early September as interbank lending has come to a virtual standstill.
Having now made the move to become part owners of the troubled banks, governments will also be in a strong position to introduce new regulations. Among other things, they are expected to further limit the ability of banks to leverage up, which will invariably lead to lower profits and returns on equity and may ultimately keep financial sector share prices under pressure. Several US banks, including Morgan Stanley and Citi, bucked the broader market trend over night, however, with gains between 2% and 3%.
Turning to the real economy, Joost van Leenders, an investment strategist at Fortis Investments, projects that a fairly severe global downturn is in store, which in developed markets will likely be more severe than those in 1990/91 and 2001. But he sees hope for Asia.
ôThe recovery, especially in the US, will be slow and modest due to the process of deleveraging that must be completed. However, a global depression does not seem likely for two reasons û the policy response and the continued resilience of domestic demand in emerging markets. Some spill-over is inevitable, but the structural strength in emerging markets is likely to be an enduring feature of the world economy,ö he says.
Meanwhile, analysts have yet to adjust their earnings numbers to reflect the new reality, as evidenced by the fact that the consensus forecast for this year, according to IBES, is for a 2% decline in earnings while the consensus for 2009 is for a 14% increase.
ôThis seems highly unrealistic and subject to downside risk, as they say,ö notes Rosgen. Valuations are a lot more realistic now than they were a year ago, but the difficulty for investors is to judge how much earnings can and will fall and that is likely to keep a certain degree of nervousness in the market.
However, as of last Friday, Asia-Pacific ex-Japan was trading at 1.3 times book û a level that, according to Rosgen, has been exceeded in 30 of the past 33 years. ôThis may not be the low, but if you had $100, youÆd put $30 in now, because 90% of the time youÆd pay a higher multipleàthose are pretty good odds.ö
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