Back on the Savannah

The process of life and death on the Savannah is the normal role of nature in the wild: corporate economic birth and death in the business world is almost identical – unless or until politicians interfere with it.

In the USA such behaviour has normally been seen as quite normal, although there have been some notable exceptions. As the heart of the capitalist empire, the ruthless culling of the weaker and injured corporate beasts is to be expected in America, but it never ceases to amaze me the number of “protected” industries that have been effectively subsidised by political vote seeking and “pork barrel” protectionism. This extends to everything from ship building to mining, and from defence to the most obvious one – the car industry.

It was therefore with some relief that, after seemingly a certain initial reluctance, the Obama administration did act to see the proper and necessary surgery on two of the most obviously injured behemoth beasts. The actions on both Chrysler and General Motors should be welcomed, and frankly could only have been achieved in that window of “goodwill” of the new President’s honeymoon period. However, this will only be the start.

Now we are seeing the true ruthlessness of the US capitalist system as bankruptcies reach near record levels. A lot of this can be measured through the number of defaulted junk bonds. They of course also go by the more comforting name of high yield bonds, which always sounds more reassuring - that is until you realise why they are providing such a high yield – higher risk. Figures show the default rate for 2007 was a mere 1%, compared to the recent running rate of approximately 9.2%, based on estimates from the rating agency Moody’s that this could rise to around 13.8% by the last quarter of this year.

By way of comparison this is in fact slightly higher than the 1991 peak level of 12.8%, but still below the record level achieved during the Depression in 1933 of 16.3%.

Such destruction is of course both sad, when seeing some famous names go down (such as Crabtree and Evelyn who recently filed for Chapter 11 bankruptcy protection) and obviously personally painful for those directly affected, but it is both normal in the economic cycle and in fact healthy. The reason being that the clearing away of the weaker businesses clears the path for the next investment cycle for the new businesses coming up to replace the fallen beasts.

In fact it is far more difficult for an economy when such actions are prevented and this sadly is now what we are seeing in the UK. There has been much talk of “zombie” banks and businesses, and I apologise - I have mentioned before the hobbled nature of the UK banks, through under capitalisation, but this has manifested itself not just through higher margins and constricted lending, but also due to their inability to write off obviously failing and doomed businesses. These structures are also in a zombie world of being the living dead – still alive but financially dead. Banks effectively can’t afford to write down such failures with so little capital, so better therefore to keep them going? Well actually not. This of course also prevents the next stage of the cycle to occur, namely to see the next cycle of investment come out of the carcass of the old beast.

The frustration I am hearing from would-be business entrepreneurs and investors waiting for this next stage to occur are now quite commonplace, and although the government may think that what they are doing is “protecting British industry”, actually in many cases they are just stretching out the painful economic weakness for longer. Unemployment is likely to be rise to more than 3 million, and in effect be over 10% of the workforce, and add to that the 2.7 million signed off as sick (and that’s without porcine sneezing) and another couple of million in various types of training, and we could have close to 20% of the potential working population not working. That’s a big cost to carry. A lot of Britain won’t be working.

Trying to delay the law of economical jungle does little to improve the situation, but extends the period of pain unnecessarily. By letting the injured beast die, we will speed up the recovery, but we will also cause further pressure of the banks for more write downs. The banking problem has not been resolved and has not gone away. Government, especially the Treasury, must face the reality that a period of further banking pain is to come and that further surgery will be needed.

Last week we saw more “encouraging economic numbers” of confidence, but still many were negative, or rather just less negative. These are not green shoots, but rather signs of mould. If I may quote from an excellent article from last week’s FT by Wolfgang Munchau, “Only a fool would take comfort from the strength of economic indicators. During a financial crisis, these indicators could be a metric of its respondents’ degree of delusion.”

So the message is to ignore the headlines and look at the real economy.

***

And finally........ is anyone else dealing with increasingly daft grandparents? This struck a chord with me.

Zurich authorities say police and fire fighters were called to the house of an elderly woman early Thursday after she reported her television set was burning. When they arrived, they discovered no signs of fire or smoke.

They found instead that the TV was tuned into a German station that in the early morning hours aired the constant image of a fireplace.

"The fire was extinguished with the press of a button," police said in a statement.

Yes but in my case we could not find the remote control anyway!

Have a good week.

Justin A. Urquhart Stewart
Director
Seven Investment Management Limited

For previous editions of our Weekly Update, please click here

This article represents a personal and light-hearted view from Director, Justin Urquhart Stewart of Seven Investment Management Limited, and is based on current financial news and events around the world. Its content should not be used for investment purposes and you should contact an independent financial adviser before making any investment or financial decision. Seven Investment Management Limited is authorised and regulated by the Financial Services Authority. Member of the London Stock Exchange. Head office: 23 Austin Friars, London EC2N 2QP. Telephone 020 7760 8777. Registered in England and Wales number 4092911. Registered office: 3 More London Riverside, London SE1 2AQ.