Is the worst of the credit crisis over? Equity markets think so. American and British stocks have hit four-month highs, with the latter up by 14% from the March low; European stocks have gained about 14% since then.
Since the rescue of Bear Stearns, investors have assumed that financial meltdown has been avoided. Some credit markets have shown signs of life and there are growing hopes that the US economy can revive later this year. But as David Roche says in The Wall Street Journal, this looks like a classic “sucker’s rally”.
As derivatives expert Satyajit Das puts it on MSN Money, “this is not the end”, or even “the beginning of the end”. This week HSBC revealed fresh writedowns and highlighted a major flaw in the notion that the worst is over: American house price falls, the malaise that started the crisis, will continue. They are deflating at a 32% annual rate now, up from 8% six months ago, and with 4.6 million homes on the market – almost double the average inventory in pre-bubble days – the outlook is grim, Stephanie Pomboy of MacroMavens told Barron’s. That portends further trouble for consumption and the economy.
And the housing problem is no longer merely in subprime. Prime mortgage delinquency rates are at a decade high of 2.3%, says Merrill’s David Rosenberg, while John Mauldin of Investorsinsight points to ongoing downgrades by ratings agencies of Alt-A (a step above subprime) debt. “More write-offs are coming in the mortgage space.” The total could match the sums already written off in this area.
Moreover, losses are now emerging in corporate bonds – “the shaky foundation of trillions of dollars of derivative contracts”, as The Economist notes – and these will worsen as the economy slides. The slowdown will also hit credit-card, commercial-real-estate, car and student loans, says Mauldin. “We are nowhere close to the bottom of the credit crisis.” This highlights a crucial problem investors have neglected, says Roche. “A recession creates a feedback loop whereby more debts go bad and more asset prices fall.”
And the credit crunch to date is only just beginning to affect economies. The latest survey of loan officers shows the crunch is spreading, with credit tightening across the board, says Capital Economics, and last week brought news that European credit standards are tightening while demand for loans from firms is tumbling. This suggests the eurozone’s slowdown is broadening following financial market turmoil. It is “at a tipping point”, reckons BNP Paribas.
With Europe’s slowdown just beginning, margins historically high – return on equity for the MSCI Europe reached a record 18% last year – earnings expectations still “highly unrealistic” and plenty of downgrades to come, “this is strength to sell into”, says Morgan Stanley. It is far too early to be buying equities.
With the hawkish European Central Bank (ECB) loath to cut rates until the region is “on its knees”, stocks are being buffeted by tight monetary policy and a strong euro; the ECB is “effectively destroying corporate profitability”, says Hugh Hendry of Eclectica. This is an “extremely inhospitable” environment for investors.
The environment in Britain isn’t looking too good either, with stocks here also “detached from current expectations” for economic performance, as Capital Economics puts it. With the downturn just beginning, a slide in non-financial, non-oil firms’ earnings of around 10% over the next two years is on the cards, and that would open the door to “some fairly sharp falls in equity prices”. With the producer price data showing that companies can’t fully pass on high costs, British firms can look forward to shrinking profit margins, added Ian Campbell on Breakingviews. The FTSE’s rally is “hard to understand”.