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It probably hasn’t escaped our regular readers’ notice that investors are not easily unnerved at the moment.
Major geopolitical events like North Korea’s nuclear bomb test have caused barely a ripple of consternation in most financial markets. And as the FT reports this morning, investor appetite for risky corporate debt is at historically high levels. AAA-rated company debt, considered the safest, now accounts for just 8% of the outstanding global debt market, compared to 15% in the mid-90s, according to Merrill Lynch.
And in fact, investors are so keen to embrace risk that the spread (the amount of extra return investors seek compared to what they can get from a completely safe asset, such as US treasury bonds) on AAA-rated debt has actually risen over the past 18 months, even as the spread on high-yield debt has fallen.
But can it go on?
The fall in the number of AAA-rated company debt issues has credit ratings agency Moody’s wondering whether it needs to lower its standards. Daniel Curry, head of corporate finance in the Americas, tells the FT: “We are wondering if it makes sense to keep the quantitative standards at the same level for triple As”.
Why is this happening? Well, it’s not just because lots of low-rated companies are now taking advantage of markets eager to lend them money – though that’s a big part of the reason. The other key factor is that previously high-rated companies are much more willing, in an environment with low debt costs, to take on more debt and happily “suffer the consequences of credit downgrades,” as the FT puts it.
And it’s not surprising. In a low interest rate environment, it’s become very difficult to get a decent return on safe assets, so even traditionally more conservative investors, such as pension funds, are seeking out riskier options to juice up returns. And from a corporate point of view, if markets are offering to lend you money at what look like bargain rates, it seems stupid to refuse.
But of course, this unprecedented complacency carries its own risks. Investors seem blind to the idea that anything could go wrong in our perfect, globalised, low-interest rate universe. But things are already going wrong. Just ask your typical over-indebted, mortgage-laden American householder.
As James Ferguson points out in this week’s issue of MoneyWeek (out tomorrow), falling US house prices are likely to hammer the US consumer. Much of their spending has been backed by money borrowed against the rising value of their homes – now that prices have gone into reverse, they may soon find their debts are worth more than their houses. Given that consumption accounts for more than 70% of US gross domestic product (GDP), any slackening off by consumers will hurt economic growth badly. And that means lower company profits.
As Merrill Lynch points out, “If… global profits cycles are getting ready to slow, investors are likely to shift back toward higher-quality stocks and bonds.” More to the point, if profits start to fall, a lot of those riskier small companies, as well as the bigger ones which have sacrificed their credit ratings to take on more debt, might start to have difficulty servicing those debts.
Most analysts and investors see no chance of this happening any time soon. But the big banks have been building up their ‘distressed debt’ teams just in case, preparing to take advantage of the downturn when it comes (for more on this, see: Are the good times ahead for the financial vultures?
Given the problems in the US housing market, we think that day might arrive a lot more quickly than most expect. After all, as Bill Bonner reminds us (also in tomorrow’s issue), very few people expected the tech bubble to burst. It’s at the times when the rest of the market is unfeasibly complacent, that the smart investor should be at their most nervous. Being contrarians, it sounds like good advice to us.
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The FTSE 100 fell as low as 6,044 at lunchtime yesterday. However, the index went on to close flat at 6,073 after blue-chips retraced their losses in the afternoon, led by miner Vedanta Resources and more M&A activity. For a full market report, see: London market close
On the Continent, the German DAX-30 closed just one point higher at 6,119. The gains were led by Deutsche Telekom on rumours that Blackstone is trying to arrange a merger with its British counterpart, BT Group. The Paris CAC-40 also closed slightly higher, gaining 3 points to close at 6,119, its highest close since June 2001.
Across the Atlantic, markets were shaken by news of a plane crashing into a Manhattan apartment block and fresh worries over the outlook for interest rates. The Dow Jones ended its winning streak to close 15 points lower at 11,852 as the earnings reporting season got off to a bad start with a disappointing third-quarter report from Alcoa. The S&P 500 was 3 points lower at 1,349. And the tech-rich Nasdaq ended 7 points lower, at 2,300, despite reaching a five-month high in earlier trading.
In Asia, concerns over US interest rates saw the Nikkei fall 13 points to 16,368.
After reaching its lowest level this year yesterday, the price of crude oil began to edge up in after-hours trading. It last traded half a percent higher at $57.89. Brent spot was at $57.76.
Spot gold made modest gains yesterday and was trading at $573.00 this morning.
And in London today, the world’s second-largest brewer, SAB Miller, announced that first-half sales had risen over 9%. The company, which makes Castle and Peroni, attributed the rise in beer consumption to this summer’s World Cup.
And our two recommended articles for today…
Will gold hit $1,000 in 2007?
– Despite recent volatility, the bull market in gold is still on course – say John Robson & Andrew Selsby at RH Asset Management. But can gold reach its next target of $1,000? To find out how the gold price is related to weakness in the US housing market, read: Will gold hit $1,000 in 2007?
‘Diworsification’: the perils of diversifying across asset classes
– Diversification across asset classes may have made great returns for some investors in recent years, but the market is about to turn against the diversifiers. For Merryn Somerset-Webb’s views on why holding everything from private equity to property is a risky strategy, click here: ‘Diworsification’: the perils of diversifying across asset classes