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‘The price of all assets will go down’

Economic growth, Financial Events, Leverage, Oil markets
By Paul Hodges on 07-Sep-2008

‘Deleveraging’ is an ugly word, and it has ugly implications. Bill Gross of Pimco, who manages the world’s largest bond fund, has done us all a favour by trying to explain its impact, and why it is likely to continue for some time to come.

He notes that all financial institutions are now reducing the leverage that they use, and as a result:

1. The costs of borrowing are rising, as more equity capital has to be used
2. These costs will continue to rise, until enough new equity capital has been raised
3. Whilst this happens, ‘the price of all assets will go down’

Pimco had long forecast that housing markets were most vulnerable to deleveraging. And once house prices began to fall, equity markets soon began to weaken. More recently, commodity markets have also been hit. Oil markets have fallen sharply, as the blog forecast back in mid-July, when suggesting that prices ‘could easily fall $50/bbl to $100/bbl’.

But deleveraging has other implications for chemical companies. Banks now need to cut back on corporate lending, to preserve their equity capital. Small companies have already seen overdraft limits cut back. Next, it will be the turn of larger companies.

This could be very painful. As recently as a year ago, you could still find companies who had convinced themselves that cyclicality was no longer a problem. As a result, debt levels were often much higher than considered prudent when I joined the industry.

This high leverage boosted earnings during the boom period. But as the blog warned back in August 2007, ‘when we go into the ‘down’ cycle, leverage will exert its same impact on the downside’.

CFOs will be very busy people in the next few months, as they seek to identify and manage their credit risk.