I have been warning about the US housing market, and especially the inventory overhang of new houses, for months now. I have always maintained that the subprime mess would spill over into the mainstream and that the US household sector, now financing consumption by net dis-saving for the first time since the Great Depression, has to crack. But I don’t think this is necesarily bad for stocks. The corporate sector is making almost record profit margins. That means they can afford to cut prices as consumers start to hurt, something that will lead to deflation rather than the oil-price-led inflation so many market commentators seem to fear. As consumption weakens, markets will care more about recession (which is a real possibility) than inflation. This will allow for more Fed fund rate cuts than many people expect and for a Treasury market rally as the economy weakens in a deflationary way.
To see how this might be good for equities, let’s first look at what the “credit crisis” really means. It isn’t today’s market that is the strange one. That was the pre-credit-crisis market. The premium that the average US junk bond has to pay over and above the risk-free rate (the Treasury yield) has ranged between about 10.63% and 2.88% over the last five years. That ultra-low 2.88% was recorded this summer, just before the “credit crisis” – that wasn’t normal.
It might have been the absurdly high default rates on newly-issued subprime mortgage debt that triggered the selling of subprime bonds and related derivatives over the summer. However, what was really happening was a repricing of risk to more normal levels. Today, the junk bond spread is 4.3%. It is this repricing of risk that has made the market happy to buy back into the US investment banks, once they admitted how big their second-quarter losses were. It isn’t because investors aren’t aware that there could be more losses to come, as mark-to-model valuations steadily give way to realised values, but because from now on they hope that the banks will expand margins and price risk correctly. This doesn’t simply mean tougher lending conditions going forward for busy borrowers, such as private equity or buy-to-let investors; it also means wider spreads for the banks (that’s higher mortgage rates, even if base rates do come down, to you and me).
HBOS chief Andy Hornby said last week that the mortgage market is to “undergo a fundamental shift” because of the increase in funding costs. What that means is that not only the increase in the wholesale cost of debt will get passed on to borrowers, but an increase in the spread (the bank’s reward for taking the risk) on top of the increased cost will be added on too. A strategy that involves offering higher cost debt to fewer people is the opposite of that pursued by Northern Rock (very high turnover driven by loan price discounting). Loans are about to be priced not for market share, but for profitability.
The first conclusion to draw from all this is that the buy-to-let boom is over and the housing bubble that it powered is also finished. Next is the fact that we should beware any other market that has been driven by rising asset prices if those assets have predominantly been bought with borrowed money. Think private equity, the model for which relies almost entirely on access to cheap debt. Note too that even the hedge-fund space will be forced significantly to scale back operations in many markets.
So is there any asset out there that will not be badly hit by the rising cost of debt? Yes there is. Equities. Relative to almost any other asset I can think of, equities are the most likely beneficiaries of any increase in debt costs – they aren’t carrying lots of expensive debt and individuals don’t borrow money to buy them. I’m less keen on the mid-cap stocks, many of which have been bid up by private-equity speculation. However, the mega-caps should remain virtually unaffected. This is why I believe the almost five-year out-performance of the FTSE 250 over the FTSE 100 is at an end. From here on, big is best. Since May 2005, UK house prices have risen 18.7%, according to the Nationwide house-price index. Over the same period, UK shares have gone up more than 40% (the FTSE 100 total return has been 48%). So clearly, the switch has already started. Investors who doubt that markets can keep rising even as economies go on falling can take heart from history. The US economy has had nine recessions since World War II, where real GDP growth slowed to almost zero or turned negative. In four of those recessions, the stockmarket actually went up. In 1954, GDP fell by 2.5% and the stockmarket gained over 40% by year-end. In 1961, GDP hit –1%, but stocks gained 22%; in 1980, GDP of –1.5% triggered stockmarket gains of over 30% – and a –1% recession in early 1991 saw the Dow up more than 30% by the year-end.
The really important issue here is whether stocks are cheap or not going into the downturn. With an estimated p/e of 12.4 times, the earnings yield on the FTSE 100 is over 8%. It also paid out 3.7% in dividends last year. This makes it as cheap compared to the returns you can get from gilts, which return less than 5% (let alone property), as at any time for the last quarter of a century at least. The combined effect of being this cheap – added to recession-triggered falling gilt yields (as interest rates come down) driving them even cheaper – is likely to far outweigh the negative impact on earnings. Just as it did in 1954, 1961, 1980 and 1991. The end of the housing bubble might just turn out to be a tonic for the stockmarket.
James Ferguson is an economist and stockbroker at Pali International. He also runs his own share-tipping service, Model Investor.