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09/01/2017

Seven again

Tuesdays, according to a 2009 report, are by some margin the rainiest days of the week in Manchester. Since the clouds have no notion of which day it is this must be the result of chance. Years ending with a seven have since 1900 produced dreadful returns from US equities: the compound capital return from the eleven years in question is -48% or -5.8%p.a. Since the Dow Jones Industrials has gone from 68 to 19945 (293 times) from 1900 this does stand out. The relationship is, of course, also coincidental but the money response to circumstances in those years is interesting and might have some bearing on 2017.

The US experience is much worse than that of other markets. The UK market, for example, did much better and returned 75% - though more than 100% of the British return came in two very strong years (1967 and 1977). I have therefore concentrated on US events with some reference to developments elsewhere.  I have concentrated on the interesting years. There are some (1947, 1957, 1967, 1977) which were mostly poor but in a dull way and I only touch on these.

1907 – The Rich Man’s Panic

The US equity market enjoyed a strong rally from its lows in 1903. The Dow industrials rose from 42 in November 1903 to a high of 103 in January 1906. Thereafter, the San Francisco earthquake in April 1906 drained financial resources to pay for reconstruction in the US and meet policy claims in Britain. Caps on railroad tariffs became law in July 1906 and lead to a fall in the value of railroad securities.

The Dow fell about 2% over the course of 1906. For the whole of 1907 it fell 38%

It softened from the start.  On 12th March JP Morgan met President Roosevelt to discuss the antitrust policy, which was undermining confidence. Despite reassurance from Morgan markets panicked with the Dow falling 9% on 14th March alone. Some writers refer to this day as the Rich Man’s Panic; others reckon the fun took place in October. For March as a whole the index fell 11% taking the loss for the year as a whole to 15%.

The summer saw the failure of a bond offering by New York City, the collapse of the copper market and a $29m antitrust fine levied on Standard Oil. There were bank runs in Japan, Germany, Chile and Egypt and the Bank of England prohibited British banks from buying US finance bills thus cutting off an important source of credit for US borrowers. The market fell 13% in the third quarter, but there was still no respite. The panic intensified as two speculators, two brokers, a mining company and a bank were pushed into bankruptcy. On 21st October a run started on the Knickerbocker Trust Company, which was one of the largest in the country. It failed triggering further bankruptcies in the whole financial system. On 23rd October money was more or less unobtainable and call loan rates shot up to 125%.

JP Morgan and other wealthy individuals pledged large sums to shore up the financial system. It appeared to work. The stock exchange stayed open on October 24th and prices started to rebound.

Next week, however, panic returned as the City of New York was on the verge of defaulting. Morgan purchased $30m of New York City bonds, organised further support for various financial institutions and persuaded the President to overcome his antitrust objections and allow US Steel to purchase the Tennessee Coal, Iron and Railroad Company.

The index finally bottomed at 53 on 15th November having fallen 44% from the end of 1906. It then recovered steadily and touched 100 in 1909– just below its peak level of January 1906 – before the next, thankfully milder, bear market set in.

The bond market was no place to hide with long term corporate yields rising from 3.75% to 4.21%. Nor were foreign markets: Barclays estimates that London stock prices fell 5% for the year and, in a year of 10% inflation (unusual then), gilt prices fell as well.

Why call it The Rich Man’s Panic? Because they were the people who owned securities and it was, of course, a few of them who rescued the situation. What was the Fed doing?  Nothing, because it hadn’t been invented yet.

1917 The Year of Revolution

For the British investor it was a grim year. Inflation of 21% more than offset a small gain for the equity index and gilts fell again. Yields on consols (certain types of British government bonds in the form of perpetual bonds redeemable at the option of the government) touched 4.99% - a level not seen since Napoleonic times. In the United States, after a strong run from the end of 1914, the Dow decided it didn’t like the reality of war and fell 17% for the year while bond yields rose about 90bps. The losses that get forgotten about, however, were the losses on Russian debt.

Czarist Russia ran into two immediate economic problems at the outbreak of the First World War.  Blockades in the Baltic and Black Seas lead to a catastrophic fall in exports. Secondly, the sale of vodka was banned, which cut the government off from over a quarter of all tax revenues. (In 1985 Mr Gorbachev restricted the sale of alcohol leading to a sharp deterioration of state revenues and helping to undermine the Soviet Union - sometimes history does repeat itself.)

So the Czar’s economic problems were a shortage of foreign earnings to pay for war goods and a shortage of tax. Domestic and foreign borrowing was the solution. British debt financing of Russia was partly secured by Czarist gold which had been deposited in London. Nevertheless, the losses on bonds, business investments and trade goods were a bit over 10% of British GDP.  Unlike stock market falls the money was gone effectively for ever – though there was small restitution in the 1980s. Here is how one investor fared. In 1914 the 11Th Duke of Bedford sold the Covent Garden estate for just under £2m. The proceeds were variously invested, mostly in British, Canadian and Indian bonds. About 4% of it, however, found its way into the 4 ½% City of Petrograd issue. All of us have made bad switches but selling something that subsequently rose over 100 times in capital terms over a century to reinvest part of it in something which gave a 100% capital loss in 3 years must be amongst the worst.

It was France, however, that bore a larger burden. Reflecting changing alliances France had replaced Germany to become Russia’s main foreign creditor during the late stages of the 19th century, and it continued to provide finance as the war progressed.  According to Kindleberger French investors lost 15 or 16 billion gold francs on the Bolshevik default. Unlike their British allies they had failed to snaffle any of the Czar’s gold to offset part of the losses. The losses on bonds alone represented; about 17% of GDP, which France was poorly placed to absorb. Would they have pushed the Germans quite so hard for reparations at Versailles if Russia had honoured its debts?

1927

Phew.  In the United States the equity market rose 27% and bond yields fell quite sharply. The London market rose 4%; gilts rallied and consumer prices fell 5%. So the thesis collapses at this point? Well, no, not exactly. Monetary policy provides the interest for the year. There were many who were concerned at the rise and level of the stock market and wanted higher rates but the Federal Reserve, following a conference in New York with the heads of the British, French and German central banks, cut interest rates by 0.5% to 3.5% despite protests by four of the regional Feds. Benjamin Strong of the Fed thought it was more important to relieve pressure on the pound than to curb domestic stock market speculation. He predicted to Charles Rist of the Banque de France that a rate cut would give the stock market “un petit coup de whisky”. It certainly did: after the cut in the summer the US market rose 15% over the rest of the year and, apart from a 10% correction in late 1928, continued rising until September 1929.

1937

Relax, we’re back in the bear pit. The UK market fell 17% but the US market fell 38% and bond yields rose in both countries. What went wrong? Policy. President Roosevelt increased taxes sharply to try to balance the budget. In addition, in 1936 The Federal Reserve had doubled the reserve requirements for banks in order to prevent ‘an injurious credit expansion.’ Tighter fiscal policy and tighter monetary policy lead to the third worst recession (behind 1929 and 1920) in the United States in the 20th century. GDP fell 10% between May 1937 and June 1938.  I don’t suppose Adolf helped.

1947

In the US equities and bonds both lost 2%. Things were worse in the UK where the equity index fell 6% and gilts returned -13%. There wasn’t anything much wrong; it was just a long slow grind to get back to normal after war time with very little certainty about the future shape of the world.

1957

US equities were down 14% but treasury yields dipped a little from 3.4 to 3.2%. Meanwhile, UK equities went down 7%, and gilt yields rose from 4.7% to 5.3%.  The US had a mild recession in late 1957 lasting into 1958 while in Britain inflation, at 4.6%, was too high.

1967

Equity markets had a strong year with the British market returning 28% as the market sensed devaluation and a move towards the centre by the Labour government. The US returned 25% but the long post war bull run was ageing and would be undermined by rising inflation and bond yields.

US bond yields went over 5% for the first time since 1921 while gilt yields touched 7% - the highest on record.

1977

In the US equities fell 7% as inflation started moving up again – reaching 6.7% at the end of the year but the bond return was slightly positive as the coupon of over 7% just offset capital losses.  After the International Monetary Fund (‘IMF’) bailout of 1976 British markets boomed: sterling rose 10% against the dollar; equities rose 41% and gilts 30%. Inflation of 12%, however, removed some of the gloss.

1987 The Great Crash

The US equity market dipped 1.4% while the UK market rose 4.2%. US treasuries returned 2% while gilts were very strong and returned 15.5%. Nice, peaceful times you might think; and you would be wrong.

The oil price collapse of 1985/6 delivered marginal deflation in some countries and very low bond yields. Oil, then inflation and growth recovered. The Fed Funds rate moved from 6% at the start of the year to 7 ¾% by late summer but the bond market ran away in a growth, liquidity and inflation scare with the view expressed that the new chairman, Greenspan, was simply not in control. The ten year treasury yield of 7% in early January surged to just over 10% in early October. The equity market paid no attention to these developments until August: the S& P 500 stood at 242 at the start of the year and reached 336 on 25th August (38% up for the year to date). Thereafter it softened a little but a number of institutional investors, who should have known better, were lulled into a false sense of security that they were protected by portfolio insurance (the notion that your manager would be able to protect your portfolio by selling index futures). The market started softening in September; by the end of the month it was 5% below its peak. The speed of the fall accelerated in October as managers tried to protect their clients’ portfolios by selling futures: by the 16th, which was a Friday, the market was down 16% for the month. The next Monday the selling pressure got out of control, and the index fell over 20% in one day. Treasury yields which peaked at 10.23% on 15th October fell to 8.7% by 26th October.

Foreign markets were no place to hide as markets had become much more strongly correlated in the 1980s.The HK exchange was closed for several days; the German market fell just as far and, unlike the American market, struggled to recover. Only the Japanese market shrugged off the problem. It fell 15% on 20th October and then started to recover. Its problems began just over two years later.

Most investors, it seems fair to say, found the whole episode pretty confusing.

But like 1907, 1917, and 1937 the following year was positive.

1997 – The Asian Crisis

US equities up 28%, bonds returned 14%. Other developed markets also had good years. In December 1996 Alan Greenspan said

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?”

In March 1997 the Fed moved the funds rate higher and rising bond yields pointed to more to come. Cheap and abundant funding in the early 1990s had lead to a build up in dollar denominated sovereign borrowing in a number of Asian countries. So long as exchange rates were pegged to the dollar the situation looked sustainable. The local equity markets spotted the problem first: the Thai equity market fell by a third in 1996 but, since the currency peg held, there was no undue concern.

Then, in June 1997, they abandoned the peg and the Baht fell. From 25 to the dollar at the end of June the Baht dropped to over 50 by the end of the year. As a result, the foreign currency debt to GDP burden doubled and looked the opposite of sustainable. The stock market continued to fall; by the time it hit its low in 1998 it had lost 85% of its value in Baht terms in two years. The contagion spread to a number of countries with South Korea being the hardest hit. Multiple IMF bail out packages followed. The deflationary impact of the crisis on inflation in developed countries encouraged central banks to loosen policy – so that the Fed Funds rate dropped to 4 ¾% and didn’t start rising again until June 1999 by which time the irrational exuberance in Nasdaq was in full swing and could not be restrained.

2007 – From Bubble to Rubble

A 7% return from the Dow, bond yields fell substantially. International markets were generally positive. Nothing to worry about?

Financial innovation: Collateralised Debt Obligations (‘CDO’)and CDO squared (remember them), the repackaging of toxic US mortgage debt, the over gearing of bank balance sheets, and the financing of stock buybacks with the issuance of high yield debt were all abetted by the search for yield by income hungry investors. As a result spreads on high yield bonds fell to new lows.  In March there was a brief setback as HSBC surprised the market with provisions but the party soon restarted. In the second quarter all appeared to be well but the new issue market in fixed income was developing severe indigestion with deals not being passed into end investors’ hands as the market started to pay attention to growing difficulties at sub prime lenders.

The storm broke in June with two Bear Stearns Hedge funds, which invested in mortgage backed securities, stopped redemptions. Credit markets started falling sharply and, in the case of high yield, didn’t stop for 18 months. The equity market joined in and gave up all its gains for the year in a fall of 11% between July and August. Rates were cut and equities rallied to new highs in early October before sliding again. Unlike 1907,1917,1937,1957, 1977, 1987 and 1997, which were followed by a year of positive US equity returns, 2007 lead on to 2008.

Conclusion

We can classify the things that went wrong.

We had policy impact: 1907, 1937. The 1907 parallel is interesting: with his Square Deal policies aimed at the average citizen and ebullient personality Teddy Roosevelt is the President least unlike Donald Trump (a fellow New Yorker). Corporate tax reform, and a concern for fairness in trade (whatever that turns out to mean) could be the equivalent of the antitrust policy.

We had tighter money: 1907, 1917, 1937, 1947, 1977, 1987. In 1987 the bond market was concerned that the Fed was not doing enough; in the other years it was concern about tightness of money.

We had financial innovation: 1987, 1997, 2007

We had the search for yield in prior years: 1997, 2007

We had the impact of a rising dollar: 1997

I am fairly optimistic about the future. I think the pro growth agenda, in particular the emphasis on deregulation and simpler and lower taxes for companies and individuals, is likely to be favourable for the economy in the medium term.  US corporate earnings are likely to grow quite healthily next year (particularly if corporate tax rates are cut) but rising rates, a strong dollar, the unintended consequences of reform, and the portfolio positioning after years of emergency monetary policy have, as they have demonstrated in the past, the potential to brew up quite a storm in financial markets.

John Birdwood

John Birdwood is Group Head of Discretionary Portfolio Management at SG Hambros Bank.

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