“An unending chain of explosions”, as Bill Jamieson puts it in Scotland on Sunday, has rocked financial markets. The MSCI World Index of 23 developed countries hit a five-year low early this week before a US-led rebound on Tuesday. This was fuelled by talk of a Japanese rate cut, which lowered the yen and eased concern over the unwinding carry trade. The main US, UK and European indices, down by around 40% this year, are near five-year lows. Emerging-market stocks fell by 15% last week. Currency markets have also been in turmoil.
Selling across all markets has intensified of late as investors have fled risk and unwound carry trades, whereby they borrowed low-yielding yen and parked the money in higher-yielding currencies or risky assets. The acceleration of deleveraging has also meant that hedge funds, partly due to restrictions on short-selling – one of their key strategies – are increasingly selling off assets to cover redemptions by investors and meet margin calls from lenders. These sales push down asset prices and prompt lenders to demand more collateral from leveraged investors, creating a vicious circle.
Computers are playing a key role here, says Gillian Tett in the Financial Times. Banks often use “value-at-risk” (VaR) models to assess the riskiness of loans made to hedge funds and their own assets. This is gauged by how the asset’s market price has moved in the past. The trouble is that over the past few years unusually low volatility “cast a fabulously flattering light” on the risk levels of assets, encouraging massive lending to hedge funds. Now that volatility has made a comeback, VaR models are showing that risk has exploded. So banks are selling assets and slashing loans to hedge funds, triggering fire sales and more volatility. “It’s a vicious trap” that has engulfed everything from sterling to Chinese shares.
Underlying all this is that equity investors, “rather slow to respond to events in the past year”, as the FT notes, are realising that the economic outlook is grim. Lousy data and the collapse of leading banks are prompting worries that the global downturn could become a depression, says Oliver Kamm in The Times. The unwinding of the debt bubble looks set to cause “enormous amounts” of economic and financial damage, says Jamieson. Britain’s third-quarter GDP contraction was worse than expected, suggesting a protracted slowdown is on the cards; JPMorgan’s Bruce Kasman is pencilling in a fall in US GDP of 4% in the fourth quarter, the worst since 1982.
IMF research covering the period since 1980 shows that recessions in industrialised countries that follow periods of financial and banking turmoil last for almost twice as long and are deeper than the average slowdown duration of three quarters. But have equity markets fully factored this in? Société Générale’s James Montier noted last week that US and European markets’ forward price/earnings ratios implied a drop in earnings in line with the last two recessions, which were shallow. But the downturn is set to be considerably worse as the burst credit bubble finally “forces the US consumer to retrench”.
More earnings disappointments thus look likely, while a long-term view of valuations also highlights scope for further downside. The so-called Shiller p/e ratio, which averages out earnings over the past decade (thus adjusting for the unusually strong recent profit growth) is at around 14.5 in the US, below the average of 16 since 1881. But the average trough figure in the recessions between 1923 and 2000 was 10.8, as Capital Economics points out – and below ten in downturns where the US economy shrank by at least 2.5%, says Edward Chancellor in the FT. Previous nasty bear markets have reduced the UK and European Shiller p/e to single figures. They are now around 12. As Tony Jackson puts it in the FT, “tin hats all round, I fancy”.