Rolling effects of downturn playing out

07/05/2009 - 00:00

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INVESTORS in listed equities are now asking how far the current rally on global equity markets can go and whether it is safe to entrust savings into those markets.

Rolling effects of downturn playing out

INVESTORS in listed equities are now asking how far the current rally on global equity markets can go and whether it is safe to entrust savings into those markets.

Briefcase thinks that we are about to see the impact of a second derivative of the financial and economic downturn (GFC), which will result in further hits to earnings though 2009 and into 2010 in the broader economy, away from the finance sector where the GFC began.

The underlying value and earnings outlook for companies listed on global exchanges was first impaired during late 2007 and all through 2008. Asset prices of all kinds tumbled, under the weight of forced selling.

Banks and other over-geared financial institutions and property companies became forced sellers of financial assets in a process commonly called de-leveraging, which flowed on to exacerbate falling prices for property and equities.

Plainly speaking, banks in the United States and their counterparties around the world, found that their balance sheets were packed to the rafters with worthless debt, owed by borrowers who could not pay and whose asset base was impaired.

These debts were far from plain vanilla, being bound up in a complex web of so called debt products, created using derivative instruments which expanded leverage on the upside to frightening and ridiculous levels, but also meant that when the borrower hit the skids, so did a multitude of the debt's owners from Basis Capital to the Margaret River local council and on to Icelandic banks and pension funds globally.

In a plot which would have been considered a masterpiece by legendary science fiction writer Isaac Asimov, this cloud of toxic debt ultimately spread around the world, inhibiting the ability of businesses to borrow funds in the normal course of their activities.

This financial paralysis led to a second phase of the GFC in late 2008, when large corporations began to fail under the weight of their debt and plummeting cash flows required to service that debt burden. Effectively, business was being strangled, deprived of the debt oxygen they need to keep the wheels turning.

Many companies have had all their equity wiped out, leaving owners with nothing and the assets now controlled by banks or in many cases, governments who had stepped in to give early support.

Since the sickening market nadir at around 3,100 points in March this year, at which point the local stock market had fallen 54 per cent from its November 2007 high, markets have recovered with the local bourse now struggling to maintain a 20 per cent rebound.

Following a raft of major corporate collapses, there is now ample and well-informed talk about green shoots of recovery, growth in Chinese industrial production, economic stimulus packages and an end to de-stocking by business, which has further reduced final demand across the economy.

However, this GFC story is playing out in slow motion and the monster is mutating faster than swine flu. The rolling impact on economies everywhere has seen significant contraction in many economies. Singapore, Germany and the US have all seen an unprecedented economic contraction of around 6 per cent during the March quarter and more pain appears to be on the way.

Companies which may have survived the credit crunch by adjusting their costs and reining in inventory are now seeing their sales fall away again, as rising unemployment begins to take its toll on demand.

Ultimately, stock markets are driven by the outlook for growth in corporate earnings per share.

The worst may well be over in financial markets, which have begun to lend again following stabilisation moves by government intervention; but out in the real world of commerce and trade, recovery will be a slow process which will see unemployment rise in Europe towards 12 per cent and even in Australia, where a booming rural sector and ongoing mining and energy project developments underpin a reasonable level of activity, unemployment will rise well beyond early expectations.

In recent weeks we have been softened up by both the Federal Treasurer and the Prime Minister for a shocker budget this month. It will be interesting to see how our market takes the news.

Many observers and investors will be expecting some tough talk, but this news could still prove to be a shock to the system which may pull the market down.

Remembering that unemployment is a lagging indicator for economic recovery, the key driver for the local stock market will be the rate of economic recovery in Asia, specifically China and India. This will feed through to commodity prices, which feeds through to local jobs.

Local housing and other property prices still look too high. The required adjustment has been slowed by government intervention during the first half of 2009, but we should hope that first home buyers, lured into the market by government grants, do not end up contributing to the problem when, as is likely, they lose their jobs and become forced sellers when they can no longer support the debt they have taken on.

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One unexpected side effect of the GFC has been the large number of 1960's music legends who have begun to tour again. Living in New York, under the shadow of Bernie Madoff, appears to have motivated quite a few to top up their coffers.

Recently we saw Leonard Cohen, whose long-time manager had apparently been ripping off the singer, but whose malfeasance had only come to light in the current climate.

Then there is Simon & Garfunkel and their $350 tickets. Surely this tour cannot be running solely because they really love staying in dozens of hotel rooms over several months.

You have to feel sorry for these guys, but it provides an opportunity for us to catch an aging rock star that can no longer make the top notes (pun intended).

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Briefcase has been wading through a torrent of quarterly reports from mining and oil companies.

It is Briefcase's judgement that Tap Oil has an underlying value for its oil and gas assets plus cash of about $1.13 per share.

Briefcase calculates that risked exploration appeal adds a further 91 cps, taking total risk adjusted target value to $1.86 per share, after corporate costs.

The company is well funded as it prepares to drill a couple of wells for oil in Brunei later this year and it will work on additional prospects for oil in the Bass Basin and gas in the Carnarvon Basin, while waiting to see how drilling in waters adjacent to its Philippines permit pans out for Exxon, later this year.

However, it is the deep gas potential from its 25 per cent held permit WA-351-P that holds the most exploration appeal for Tap shareholders. Recent 3D seismic data acquisition sees Tap's management team excited about the probability of finding some serious gas pools, but drilling is unlikely until 2010.

Cash flow will be reduced for 5 months from mid May as its Woollybutt project is shut in while the production gear moves to Singapore for a refit, prior to returning in December to recover the remaining 10 million barrels of Woollybutt oil. Overall, this move is likely to improve the net present value of remaining Woollybutt reserves, since the oil price is likely to improve in 2010, resulting in a better return for the company by leaving the stuff in the ground for 6 months.

n Peter Strachan is the author of subscription-based analyst brief StockAnalysis. Further information can be found at Stockanalysis.com.au.

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