“Black Mondays used to be a once-in-a-decade event – now they’re coming along more regularly than a London bus,” says Manoj Ladwa of ETX Capital. This time the Dow plunged below 10,000 for the first time since late 2004; the FTSE 100 lost 8%, its third-worst fall on record; and the pan-European DJ Stoxx 600 posted its worst daily fall since the 1987 crash, losing 7.2%, as the crisis in the European banking sector deepened. Markets continued to slide on Tuesday, with the S&P 500 hitting a five-year low.
Firefighting across the world
It got worse as the week went on. First a “fire-fighting operation” saw the unravelling of a planned rescue for Germany’s Hypo Real Estate, a major property lender and local government financier, thanks to the commercial banks involved finding that the money they had promised Hypo wouldn’t be enough. In the end the government stepped in with a €50bn bail-out. Then the tri-nation bail-out of the Belgian-Dutch bank Fortis started to go awry forcing the Belgian and Dutch governments to scoop up the bits they hadn’t already nationalised and then sell on a stake to BNP Paribas. Then UniCredit, Italy’s second-biggest bank, opted to raise capital only days after it said it didn’t need to tap the markets.
Meanwhile, national governments across Europe scrambled to increase the limits of their deposit-protection schemes and the EU agreed a set of joint principles to guide bank bail-outs. These, being widely deemed to fall short of the systemic approach needed to stem the crisis of confidence, impressed no one. Still, no one ended the week as badly off as Iceland where the crisis reached such a point that, rather than bolster its banking system, the authorities were trying to “save the country”, says Economist.com.
Matters were not improved by the dawning realisation in the markets that the US bail-out programme is not a cure-all. The hope is that removing banks’ illiquid toxic assets from the system by buying them up will encourage banks to lend to each other again and ease the credit crunch. But the key problem crimping bank lending is a shortage of capital, and only if the government overpays for the toxic assets (which looks unlikely) would bank capital actually be bolstered. As it is, banks look set to keep shrinking their balance sheets and thus undermine lending and growth.
A squeeze in the money markets
The immediate problem – this squeeze in the money markets – intensified early this week. Despite the Fed again increasing the size and scope of its liquidity programmes and the European Central Bank making another cash injection, the cost of borrowing in euros for three months has hit another record.
One ongoing worry behind all this is the unregulated credit default swap market. Creditors who took out insurance on the debts of the banks that have recently gone under are looking for their cash. But the burden of making these payments could cause new failures among those other financial institutions responsible for them, notes Liam Halligan in The Sunday Telegraph. Worse from a real-economy point of view is the fact that the breakdown in lending between banks has “ensnared companies”, notes the FT. The market for commercial paper – short-term, high-quality debt that companies use to fund everyday operations – has shrivelled by $200bn in the last three weeks, and by $600bn since last summer.
At the same time retailers have had trouble financing purchases of holiday-season inventories, says Economist.com. And according to one car dealer, banks are “looking for every excuse to say no” to those looking for credit: “we’ve gone from a credit crunch to a credit crisis”. The Fed will now try to ease the strain on businesses by buying commercial paper directly from issuers. Similarly, the state of California has warned Washington that it may need to ask for a $7bn loan as it has been shut out of short-term funding markets of late. States often have to rely on short-term “revenue anticipation notes” to cover gaps in cash-flow; these days financial institutions are no longer so keen to buy them, says Lex in the FT.
Slowdown gathers pace…
The latest seizure in the money markets bodes ill for lending and growth. Even before the squeeze of the past fortnight, the availability of credit for households and companies in the UK had fallen further, according to the Bank of England’s credit conditions survey for the third quarter. Now companies needing to refinance debt face tighter credit; default rates could “triple or quadruple in the coming months”, says Eric Benedict of AlixPartners. The economy is already looking increasingly sickly, with the latest survey of the services sector pointing to a contraction in growth in the third quarter, notes Capital Economics. In the US a manufacturing index hit a seven-year low and the biggest monthly drop in payrolls since March 2003 in September also shows that the downturn is gathering pace. September car sales were down 27% year-on-year amid what Morgan Stanley calls a “massive consumer retrenchment”. Consumption is now likely to decline at an annualised pace of 2.3% over the third quarter, says Capital Economics. All across the world, says Edward Hadas on Breakingviews, “the credit crunch has crossed the financial/real-economy barrier”. Companies and individuals are having more and more trouble getting hold of credit, “and are too frightened to spend it even if they could”.
…and goes global
The latest ructions in the money markets threaten to put further downward pressure on Asian growth. Interbank rates have jumped in Singapore, Korea and Hong Kong, where HSBC has raised mortgage rates for new customers by 0.5%, thus denting sentiment towards the housing market. In India, ripples from the credit squeeze have helped drive up financing costs, notes Peter Stein in The Wall Street Journal. Power firms are now paying 14-15% for debt that used to cost 8%. Meanwhile, Morgan Stanley highlights the commodities slump and Asia’s dependence on exports as two other reasons growth is likely to slow further. It sees southeast Asia growing by just 4.1% next year, while UBS’s Duncan Wooldridge expects “recession-like conditions” for Asia ex-Japan.
Throw in the fact that Chinese iron ore imports from India have now more than halved since April, and it’s no wonder fears of a sharp global slowdown have sent the benchmark CRB commodities index down 43% from its July record. Oil has slid below $90 a barrel now that the market has acknowledged that “this credit crisis is a global phenomenon” and oil demand from India and China is set to slow, says Phil Flynn of Alaron Trading. Bloomberg.com cites a Merrill Lynch note suggesting oil could fall to $50 next year. Capital Economics sees scope for metals to slide by another third from here. The commodities downdraft is being made worse by leveraged speculators fleeing riskier assets. Another manifestation of global deleveraging as risk aversion mounts is the decline of the carry trade and the rise of the yen. Investors borrowed low-yielding yen and changed them into higher-yielding currencies (or used the money to buy riskier assets such as commodities). Now, currency market volatility and a flight from risk is reversing the trade, bolstering the yen.
Rate cuts won’t help
Might more interest-rate cuts, such as those we saw on Wednesday, by central banks give economies and stocks a lift? They may well provide a short-term confidence boost, but it’s hard to see much practical benefit. Previous cuts in US and UK rates did nothing to improve matters – turmoil in the banking sector prevented the benefits of cheaper money flowing through the economy, said Neil Hume in the FT. Even if rates come down, cash-strapped banks are sitting on cash as the economic downturn gathers pace and thus are unlikely to lend – and indebted consumers will be loath to borrow. That’s what happened in Japan in the 1990s. Rate cuts “can’t swiftly undo the implosion of post-bubble banking”, as Ian Campbell says on Breakingviews.com.
Given the global outlook, and mounting fears of a deflationary slump as sliding economies and asset markets further increase losses at banks, making them even more reluctant to lend and thus further undermining growth, the outlook for stocks is hardly compelling. Many investors are still hoping for a V-shaped economic recovery and they “are going to be quite disappointed”, Richard Bernstein of Merrill Lynch told Barron’s. In the US, earnings estimates are still unrealistic, he says. Meanwhile, analysts are pencilling another 20% of earnings growth over the next two years in Europe, while Asian profits are also tipped to expand rapidly next year. It is unlikely to happen. Instead, expect a recession or even possible depression that will last for many years to come.