Credit Contagion and the Domino Effect

Includes: DIA, IEV, QQQ, SPY
by: Richard Kang

I’m surprised that it’s only now that we’re starting to hear the term “contagion” used more often in the financial press about the current predicament seen globally and especially in the US.

Over the past couple of years, I’ve mentioned in passing to different people my concerns regarding the economic outlook of the US. The way I see it, the typical American consumer (”super consumer” may be more appropriate) who is feeling the noose tighten from their mortgage obligations could soon make decisions that would have an effect on other forms of credit.

Car payments are one area. We’ve seen GM (NYSE:GM) trim operations yet again and with good reason … why would any sane person by a Hummer? I doubt that the typical buyer of an H2 has child seats in the back row and strollers folded behind them. That large demographic of young families would likely buy a minivan, smaller crossover or wagon. I can see the benefits of a pickup truck for many buyers but there’s a large group of models from the domestic automakers that simply have to go given that their target market is so small. High gas prices is just the final reason to adapt and the rationale for GM to make such maneuvers now while the Japanese and Korean automakers seemed to figure this out at least 5 years earlier gives good reason for top management in Detroit to be given the boot. Perhaps management wanted to take action long ago but government incentives and strong union action simply delayed the inevitable.

The real credit concern I have for Main Street, however, is when mortgage and auto related obligations lead to greater use of credit cards as a safety net. Maybe it’s just me but “credit card” and “safety net” are opposites. About as far apart “opposite” as Stephen Hawking and Homer Simpson despite their link to quantum mechanics. Yet, what are their options? Bank loans will be clearly harder to come by. Methods of the past such as home equity loans are no longer available. We’re quickly in a different world. The pressures to consume will have to be restrained but I’m no sociologist and I only wonder if the real fear of “losing it all” will curb spending patterns. I foresee trouble with auto loans affecting the domestic auto industry as similar problems with credit cards would affect Wal-Mart (NYSE:WMT), restaurants, leisure/gaming/travel and so many components of the economy. Banks will try to stimulate spending just like homebuilders are now pushing “buy one house get one free” deals.

At the end of the day, I think it will be market forces that hit the consumer with the final blow of reality. Unfortunately, I feel like mortgages are just the beginning. It could be the first of many domino trails that fall in sequence and all we can do is watch. It’s the growing social fear that should help in increasing the average savings rate even a little which I think is all we need … nothing too drastic. Or maybe I’m just keeping expectations in check.

As an aside, I should add that the consumerism of North America is clearly growing globally to other markets. It’s not just Dubai but major centres all over the emerging world be it East Asia, the Mideast, Latin America or Russia/Central Eastern Europe. We’re hearing constant reminders these days of rising food, fuel and housing prices globally and this includes the developing world.

Yet there is simultaneous high growth in the sale of luxury goods. Hand made Swiss watches, Italian cars/motorcycles, designer handbags, cigars … the necessities of life I suppose. Or you’d think that by visiting these regions. There are some neighborhoods in large North American cities dominated by high end automobiles. However, I’m always surprised at how this pales in comparison to what I can only say are the new centres of influence around the world. Dubai was a bit of an eye opener but now I’m interested in seeing what Moscow is like. Of course, the spread between the “haves” and “have nots” is very significant in the developing world but it’s surprising just how wide the disparity is. But all things eventually swing back the other way. The typical middle class US consumer will learn to adapt just like the typical Japanese worker figured out that the concept of lifetime employment with one organization is over.

So what other areas of the credit space will hit the everyday consumer not just in the US but for the growing “big spender” global citizen? Like auto loans and credit cards, each of these other potential chain of dominos are all part of a growing credit contagion that would have far reaching implications to the capital markets. To what degree and for how long, no one can say now and the economists will have to build new models to figure this out. I wonder if the parallels to the depression era will continue and be a basic assumption in these models.

Since my blog is “The Beta Brief”, I’d like to link the above commentary to the industry of beta oriented instruments. Both the ETF and derivative markets will have to be less US centric and gain further access to international markets and especially the developing world. Perhaps we’ll see the same result of redundant product offerings. With all the unnecessary, overlapping exposures in the ETF space that are especially focused on the US equity markets I can only assume that many of these funds will close down or merge. At this point, the recent closures at Ameristock of five Treasury bond ETFs in addition to those from Claymore a few months earlier are a telling sign of the excess of product growth that has been a defining story in the relatively short ETF saga. Well, it’s actually about 15 years. But if the writings of Fareed Zakaria and Mohamed El-Erian give insight into the future significance of the US economically and politically, the real attention of investors … and ETF providers … should be internationally.

In the US, there are just about enough ETFs available to establish any sort of international diversification by region/country, sector, market cap or theme with very few holes remaining. However, we certainly don’t have that full availability of products in other jurisdictions. It may never get to be as crowded elsewhere as it is in the US now. It’s just a matter of time before the ETF industry expands in a more robust way to other parts of the world.

The current volatile environment with strong up days like Thursday (June 5th) but with even more down days does not seem like the best of times for passive instruments except perhaps for levered long and inverse exposures … basically, derivative markets and ProShares ETFs (I know, there are other providers now with levered long and inverse ETFs aside from ProShares and Rydex).

The past year has been the time for hedge funds. Like the bear market of 2000-2002, we should see many hedge funds, but certainly not the majority of them, perform well but many investors in them come away somewhat unsatisfied. My guess is the final result in this downturn will be even less palatable for the vast majority of investors in hedge funds. Of course, those that do find success will have it big. It’s black swans and higher moments to the extreme. But I wonder if the strength in the ETF market which took place since 2003 was the result of investor dissatisfaction with the performance of active managers during the preceding market declines. And if so, will there be the same result at the conclusion of this rocky period?

click to enlarge image

The chart above would provide a more useful picture if the vertical axis was logarithmic. However, we can see that the current market declines of the past 11 months or so are still relatively small in comparison to what occurred earlier this decade. The same is true for the DJIA and the Nasdaq as well as international markets.

Who knows what the maximum drawdown will be from the highs of July and October ‘07? I’m starting to think that we might be in a longer term sideways market where the S&P bounces somewhere between 1,200 and 1,600 for a few years with continued high volatility … again, hedge fund heaven. If we have anything close to this scenario in our highly synchronized global market - well, actually anything other than a strong bull market like we saw from early ‘03 to mid ‘07 - then this should be a great time for active management as opposed to passive. In this scenario, passive management will be seen as something for old “has beens” and we’ll hear the same arguments against indexing as we heard in 2002.

However, I think that the ETF industry has become, and will continue to be, less about buy-hold and a Vanguard-like philosophy but rather about the use of passive instruments within active strategies. Deb Fuhr (formerly of Morgan Stanley … anyone heard where she’s headed?) recently came out with a report noting that hedge funds are the 2nd biggest users of ETFs after financial advisors. Clearly, the active trading of ETFs, like it’s been in the derivative markets, will be hot and I see a growing list of managers of all types employing the use of ETFs in addition to single securities. I’m surprised how many managers I find today who use ETFs only within highly active mandates.

Funny enough, I hear these managers asking for more product related to foreign exposures and more niche offerings. It’s exactly where the industry has been headed in the past couple of years. We can see evidence of this with the continued success of ProShares and their move to foreign markets. Their levered long and short exposure funds are catered to the active investor. For those of you who are wanting some similar instruments that access certain commodity markets, ProShares manages ETFs for Horizons BetaPro here in Toronto providing long and short exposures to gold, oil, natural gas and agricultural grains. [Note: This isn’t a recommendation in any way. Just pointing it out to you.]

Like the Asian contagion of ten years ago, this is a time of serious crisis providing opportunity for the most active of active managers to shine. The long-term oriented investor will have to conduct a serious gut check to determine how their asset mix pie will deviate, if at all, should they consider the next five years or so to be anything but an up market similar to the past five years ending this past December. Another term making the rounds in the financial press recently is “depression”. Since I don’t see the US economy or the world as a whole going down to that degree (one of the reasons for my view of a sideways market over the next few years) the only form of depression I find applicable today is that related to mental health given the fear and then realization that the “American Dream” for many might be delayed and unfortunately for many more in the middle class, quite unattainable. This sad situation applies globally due to the spread of this credit and liquidity crisis beyond the US.

However, the real key problem is the US. Fareed Zakaria’s article notes that the global shift we see today is less about the decline of the US and more about the rise of everyone else. His argument make sense given its lead in innovation, among other advantages, that come out of the robust economy that is the US juggernaut. But it will be the resiliency of the US consumer (along with their government and central bank to assist them) and their ability to adapt to this credit/liquidity crisis that will determine the course of things to come in the next few years.

For the most basic investor, the simple hedge might be increased allocations to international and especially emerging market exposures via decreased US exposures. That likely won’t be enough though and the importance of alternative investments, skill in picking successful active managers ahead of time and the ability to wrap this within an effective risk protocol might be what’s required. It’s a tough world.