October 15, 2000

Global wealth disappears down the glughole

Posted in Banks ·
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What a week! Shares in Motorola, the world’s second largest mobile phone manufacturer, down 15 per cent. Shares in Yahoo!, the world’s largest internet portal, fell 17.5 per cent. Lucent Technologies, the world’s largest telecommunications equipment producer, down 31 per cent.

Dell and Intel, the biggest beasts of the high-tech world have seen their shares down by 30-35 per cent in the past fortnight. Apple Computers is sinking like a stone and most of the dotcoms, having recovered a bit over the summer, are once again trading at a fraction of their peak valuations. Since September 1 the Nasdaq Index has lost over 34 per cent of its value.

In Europe the story is similar. Telecoms across the board have taken a hammering. In fact, some commentators are going so far as to say that many of the biggest telecom names are now akin to junk bonds with huge, unsustainable borrowings.

Given the collapse in their share prices, many investors seem to agree. Today there is a deafening, sucking sound dominating the global financial markets. It is the sound of billions of dollars of global wealth disappearing.

As day-traders and online investors see their savings evaporate into thin air and many others experience a substantial drop in the value of their managed pensions, a sense of real panic has gripped the markets. Taken together with the oil price spike to $36 a barrel, people are now entitled to ask where this roller-coaster is heading.

To answer this question, let’s see where it all began. Arguably, two seismic structural shifts occurred in recent years that have made stockmarkets inherently more unstable and which may partly explain the current volatility.

The emergence of private investors as significant players in the market has dramatically changed the rules. In the past, large funds such as Irish Life dominated the market. Now, with the explosion of online trading and phone-based broking, private individuals account for up to 50 per cent of all stock holding (up from 10 per cent in 1996 according to US investment bank Salomon Smith Barney).

In addition, we’ve seen new investors getting carried away by the hype, snapping up privatisations and the high-tech IPOs as if there were no tomorrow. In this regard, JP Morgan’s adage “nothing so impairs your judgement as the sight of your neighbour getting rich” appears to apply (certainly this was the case with Eircom).

This change in ownership has reinforced a herd instinct. When the market is going up, all these new investors jump on the bandwagon, driving the dotcoms and telecom shares through the roof. When things turn around, the opposite prevails. Such behaviour might explain why, for example, the shares of amazon.com peaked at $400 per share and troughed barely five months later at $28.

The second structural shift has been the change from an almost unquestioningly blind belief in some dreamy technological future to the realisation that all firms, no matter how they operate, need cashflow to survive. Such new conservatism on the part of investors has not only caused a re-rating of dotcom shares but has also prompted a second look at the wisdom of telecom companies spending and borrowing absolute fortunes to secure third generation licences and the like.

When good companies begin to issue huge amounts of debt to pay (over the odds) for licences, investors are right to question when exactly all these putative profits will materialise. Servicing the debts will obviously be a net transfer from the company to the syndicate of lenders not the shareholders. Therefore, the share price has to fall to compensate.

Consequently, economics and fundamentals, which had been ignored by the herd over the past 18 months have come back into focus in a big way. The only thing now determining the markets is the outlook for the US economy.

This week’s obsession with profit warnings and earnings (which so damaged the high-tech sector) evidenced the return of the old pre-Yahoo way of looking at the market.

Today the questions are whether they can sell enough mobile phones, how much advertising revenue the website is generating, who’s going to pay the bills and what happens if all of the cash raised last year runs out.

To answer these questions, we turn to an assessment of the near-term prospects for the ‘Goldilocks economy’. With the economy operating at full capacity, the current account deficit widening and the rate of inflation within a whisker of where the Federal Reserve is comfortable, it is hard to expect a reduction in interest rates.

However, the disappearing wealth of the investor class should reduce the number of 4x4s bought this Christmas, although this slowdown will take time. Naturally, the dollar should begin to fall gradually ahead of a slowdown, allowing not only the US to adjust but the rest of the world too.

But here lies the rub. The Americans are both unwilling and unable to talk down the dollar. Unwilling because they have a current account deficit to finance, and unable because recent events are reinforcing the old view of the dollar as a safe haven. With tensions in the Middle East and oil prices rising, cash is flooding into the dollar. This might continue for some time.

Therefore, although the US economy may slow down internally because of negative wealth effects associated with a plunging Nasdaq, the US is likely to have a currency that is still behaving as if the economy were performing at full throttle. This implies that when the dollar eventually adjusts, it could be like the cartoon roadrunner who careers off the side of the cliff, stays suspended in the air for a few seconds and then comes crashing down.

If this proves correct it means that our inflation rate (apparently determined by oil and the weak euro) will get much worse. Pay will rise to compensate.

Just when we thought we had weathered the storm, the dollar collapses, the euro goes through the roof and our competitiveness suffers a negative double whammy. Here’s looking at a winter of discontent.