Predatory wild animals are known to drag their recent victims through the undergrowth away from the site of the attack before finishing them off at leisure. Events in the credit markets over the past month show every sign of a limp and increasingly lifeless corpse being dragged away.
We wrote, in early April, about our concern that central bankers might have lost control (Have central bankers lost control?). In our piece we looked at the global bond market’s bull steepener yield curve, a shape maintained by the extravagant generosity of the Bank of Japan (Official Discount Rate still just 0.5%) and the financial market excesses which have followed. In particular we examined the inflation of a massive credit bubble, a bubble we felt was completely unsustainable. We proceeded to consider the ability of the bloated credit market to rescue itself from its own excesses and concluded that it was, like an overfed Wilderbeast, a disaster waiting to happen. So it has proved to be in the financial market as bank after bank has begun to low mournfully as the sun begins to set on a day of gorging excess.
A phrase that seems to be being brought out of the sideboard and dusted off again is that “liquidity can take months to get established in the financial markets, but just a second to evaporate”. How true! Despite the likes of Bear Sterns, IKB, BNP Paribas and a host of others fessing up to their earlier mis-deeds, we still believe the train wreck that the credit market malaise has become is still in its infancy. Clear evidence that confidence has been rattled by the pick-up in risk aversion and increase in financial market volatility is not hard to find. The wounded animal leaves clear tracks as it’s dragged away.
Below we reprint the chart showing the Chicago VIX Volatility Index over the past decade. It shows, very clearly, that market volatility has surpassed the levels of late-February / early March, the point at which the ongoing crisis in the US sub-prime market first began to manifest itself and is now back to levels not seen since the immediate aftermath of the terrorist atrocity of 9/11.
As if further evidence of investors increasing disinclination to go anywhere near the festering cadaver were needed recent data shows that investment banks only managed to scrape away $6.2bn new mortgage backed securities in July (in fact the writer is quite surprised that the number is as high as it is!) but that figure does represent a 65% reduction in the $135.3bn divested in June. Concerningly, but hardly surprisingly, the crisis that emerged in sub-prime mortgage lending in the United States has spread like a virulent form of “foot in mouth” disease into the next layer of mortgage lending, the so-called Alt-A which, combined with sub-prime, represents a staggering 20% of the total US mortgage market.
Whilst the Federal Reserve maintained its hawkish stance in the statement accompanying its decision to leave US base rates on hold at its early August meeting, for sub-prime borrowers borrowing rates have increased by 1.25% over the past few weeks as lenders have moved to tighten lending conditions aggressively in the wake of political sensure. As noted in last week’s Week In Preview (Have central bankers lost control?), we strongly believe that the rhetoric belies the Fed’s real feelings towards the US economy and that at some point over the next four months conditions could become so severe (sharp equity market set-back or major financial institution in trouble…American Home is not enough!) as to force the central bank’s hand. There are a large number of examples from history regarding the Fed’s acting “behind the curve”, many of which we have drawn attention to in previous publications and the tenth anniversary of one (the Asian crisis of 1997) is now at hand!
Just as a pack of lean and hungry lions might tear through a herd of defenceless cattle, so the financial community is nervously huddling together, looking this way and that for indications as to which direction an attack might come from. The analogy is appropriate. There are now so many directions from which a gust may bring the unwelcome scent of something in the long grass that it is hard not to share some of the sense of impending misfortune.
The trouble is that the last time US consumer spending declined on an annualised basis, bringing with it a shallow recession, was 1991 and data was exacerbated by a single severe quarter. One has to travel back to 1980 for the last really severe consumer set-back in the US and many of the operators in the financial markets at that time have, or are on the verge of, retirement. 1980 was the last year in which the US economy suffered a really deep and lasting recession. Little wonder that investors have grown comfortable living off the fat of the land for so long, or that those operating in the market and warning that the conditions of the past are in danger of being repeated, have been scoffed at and that an extraordinary sense of comfortable insouciance has descended as might the effect of a hot sun on a lazy African afternoon.
It hardly needs us to point out that the unfolding crisis in the US residential property market is unfolding with terrifying speed and is no longer limited to that segment of the market described as sub-prime. The financial institutions’ gluttony in the wake of Mr Greenspan’s largess in 2002 has done enough to ensure that the ramifications of mortgage market excess are likely to be felt far far further than simply sub-prime.
In the context of an over-stretched financial system and an over-indebted consumer, the knock-on effects of contagion cannot be ignored. It is easy to see how the follies of sub-prime lending might (and have) extended into the wider mortgage market, to consumer credit and finally to the overall credit market. Combine this with severe indigestion on the part of those financial institutions greedily soaking up dubious quality synthetic products to the point where they can physically take on no more and the seeds have been sown for a widespread and potentially catastrophic credit crunch.
Take it from us, the failure of Bear Sterns hedge funds does not represent the failure of a group of rocket scientists (or PHD’s in the case of Long Term Capital Management) in some distant and esoteric corner of the market, it represents the failure of the now phenomenally popular and widespread demand for aggressively leveraged synthetic instruments such as credit default swaps, collateralised loan obligations based on something all too familiar.
Bear in mind that the US residential property market is the single most important lead indicator of future economic activity in that country. A severe downturn in consumer spending, which is not unlikely given already high levels of personal indebtedness, really could prove to be the straw that finally breaks the camel’s back. Financial market operators have a vested interest in turning their backs to danger. How many people foresaw the Asian market collapse of a decade ago?
As investor appetite for risk ebbs and liquidity drains away are we on the brink of the first deep US recession for twenty seven years? As far as stock market investors are concerned the hope must be that some form of defence exists to prevent the contagion in the credit markets spreading into the equity markets. We mentioned in our 3rd August publication that rising corporate earnings expectations provides some useful high ground, however, it is questionable as to exactly how long the corporate sector can withstand the impact of a severe economic slowdown. Ironically, in the context of the anniversary of the Asian market crisis of 1997, it might be the geographical diversity inherent within the largest quoted companies which provides some safety.
Two things are worth adding (at the last minute) in the context of substantial liquidity injections by both the Federal Reserve and the European Central Bank. The former increased its liquidity provision for the markets by $24bn in two open market operations. The ECB injected €94.8bn in the wake of similar signs that liquidity might be drying up.
The level of the ECB’s move, in particular, is unprecedented and indicates its willingness to act fast and aggressively to ensure that markets continued to function normally and that liquidity (which had been threatening to dry up) did not do so…for now! The moves did succeed in ensuring calm was restored to money market operations, however, the underlying problem (as expressed in this article) and its fundamental cause (see: Have central bankers lost control?, April 2007) have absolutely not gone away. As the Friday 10th Aug Financial Times Lex column puts it: “The real question, therefore, is not what the ECB knows, but what the 49 banks participating in yesterday’s operation know – or fear”
The second point is that investors should not give up on equities after a few sessions of hefty falls. The time to have given up on equities and locked in profits was probably about a month ago as benchmark indices reached, and in a number of cases exceeded, previous all-time highs. In volatile times such as these look for the largest companies, those with significant geographical diversification and those with strong and reliable cash flows. The shares of those companies where dividend yields are approaching their price earnings ratios look increasingly compelling in an environment in which total return, rather than capital growth, takes centre stage.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley