Last week was “completely insane”, says Edmund Shing of BNP Paribas. Credit markets virtually seized up and equities plunged early in the week amid the failure of Lehman Brothers and the Fed’s rescue of AIG. On Wednesday, the news that a supposedly ultra-safe money-market fund had lost money on Lehman debt sent the yield on four-week Treasury bills below zero, even lower than in the Great Depression. Investors were paying Uncle Sam to hold their money.
By the end of the week markets were posting record-breaking rises after the US authorities announced a $700bn bail-out of the financial sector and both Britain and America banned short selling of financial stocks (see below). Early this week uncertainty over the details of the plan dented confidence in equities and interbank rates remained elevated, while the cost of the bail-out plan – it could add 4%-8% to the American budget deficit – fuelled worries over the US government’s finances and wiped over 3% off the dollar-euro rate.
The broader problem is that while a financial meltdown may now have been avoided due to the bail-out plan, “the payback for the boom years” will drag on, says Paul Niven of F&C. One issue is that highly indebted financial institutions short of capital are deleveraging, implying a downward drag on asset prices. Gillian Tett in the FT cites research showing that if investment banks cut leverage levels from recent levels of around 30 times to 20 times, it would trigger $6trn of asset sales.
While the financial sector should eventually be much healthier once it gets the toxic assets off its books, “it is still in a critical condition”, says Capital Economics. There will be no return to carefree lending as capital is still short. As Mark Zandi of Economy.com tells Bloomberg.com, “banks are in survival mode… they’re not interested in extending credit”. In short, don’t count on the squeeze, which has already reduced household credit growth to its lowest level since 1970, to ease anytime soon.
Moreover, the macroeconomic backdrop is deteriorating, with industrial production falling by the most in three years and consumers “coming under the twin pressures of falling wages and rising unemployment just as their net worths are declining” amid the sliding housing market, says Sandra Ward in Barron’s. As the economy slides into an official recession, corporate defaults are set to shoot up, implying more losses at banks and a further restriction of credit.
It’s hardly an auspicious backdrop for earnings, which are still being rapidly revised down as “analysts are still playing some serious catch-up”, notes David Rosenberg of Merrill Lynch. Downgrades far outweigh upgrades at present. Meanwhile, the S&P’s p/e, based on average earnings over the past five years, has merely fallen back to the average since 1973, as Capital Economics points out, while Goldman Sachs says the average bear-market decline since the late 1950s has been 32%. This market, following a massive credit bubble, has so far declined by 22%.
British stocks also look far from compelling. Recession looms, while sliding global growth is “bad news” for the UK market, with its heavy weighting of mining and international firms, says Neil Hume in the FT. The dividend yield on the FTSE All-Share has now eclipsed that on the ten-year gilt, which last occurred at the bear market nadir in 2003. But this could well be a sign that the market expects dividend cuts; Hume notes that the yield on the market, excluding financials, is still below the gilt yield. What’s more, in 2003, corporate profitability was rising to “record and unsustainable levels”; it is now falling and “even a revived banking system would do little to stop that”, says Tony Jackson in the FT. Don’t count on the US bail-out marking “the great turning point” for markets. There’s “a long way to go”.
The big picture: don’t scapegoat short-sellers
“The knee-jerk reaction of politicians to find a scapegoat… is just mind-blowingly stupid,” says Simon Denham of Capital Spreads, commenting on the hounding of short sellers.
Shorts pump liquidity into markets and help bring share prices to levels that reflect fundamentals. They simply point to an underlying problem – in this case a lack of confidence in banks – rather than cause it. This is reflected in the fact that a mere 3% of HBOS’s stock was on loan before the stock slump that ended in the deal with Lloyds.
The ultimate blame for this mess lies with loose lending standards and the low interest rates that encouraged them.
Nice work…
While Lehman staff in London have been worried that they may not go on receiving their basic salaries for much longer, up to 10,000 staff at the bankrupt bank’s New York office are set to receive $2.5bn in bonuses.
UK staff are upset because, before the bankruptcy, $8bn was transferred from Lehman’s European operations to the US, which made paying this month’s UK salaries harder, says David Prosser in The Independent.