Credit Crunch Prompts Market Falls
Markets suffered sharp losses over the past few days, amid signs of a credit contraction (or crunch, as termed in the press) prompted by continuing concern over the extent of the problems emanating from the US subprime mortgage market, where default rates on loans have climbed drastically over the last year.
The collateralised debt obligations (CDOs), which are bundles of these high-risk mortgages sold onto other financial institutions, are held quite widely across the world, and have historically been difficult to price. Doubts over the efficacy of some of these holdings have led to large write-downs by institutions holding them and some, including hedge-funds, have had to write off very large amounts. Banks and other financial institutions have become more wary of lending to each other as counterparty risk is perceived to have increased, and this decline in the availability of credit has led to further concerns that it may slow global economic growth.
Financial stocks have been among the worst hit during the stockmarket falls, as banks found themselves unable to pass on funding commitments for leveraged buy-outs, with investors rejecting the terms of the bonds and loans offered to them. Last month, Bear Stearns bailed out two subprime focused hedge funds. It has since said one of them has "very little value" and the other is now worthless.
Fears have grown in recent weeks that the downturn in the US housing market, prompted by more people’s inability to pay their mortgages, will cause instability and retrenchment in the wider US economy. Chairman of the US Federal Reserve (Fed), Ben Bernanke, said that credit losses associated with subprime mortgage failures were "significant" and warned that the crisis could cost up to US$100bn. Putting this in perspective, although a US$100bn loss is equivalent to 0.7% of current US GDP, the Savings and Loan crisis of the 1980’s ultimately cost taxpayers US$150bn, equivalent to 2.6% of GDP in 1990.
Surge in Volatility
Global equity markets have seen a spike in volatility over recent weeks. The past week has seen a surge in volatility, with the Chicago Board Options Exchange’s Vix index – a measure of equity volatility – hit a 52-week high early on Friday before moderating slightly. In the UK, the FTSE 100 index has witnessed daily movements of over 100 points in seven of the 14 days to 10 August.
Rising volatility is an inherent part of the second half of a business cycle expansion and, although the current crisis has been contained within the housing and financial sectors so far, there is likely to be a greater volatility in markets going forward.
Central Banks Intervene
Central banks have sought to contain the credit crunch by injecting huge sums into the banking system, with some making their largest intervention since the 11 September 2001 terrorist attacks. The Fed, Bank of Japan and European Central Bank (ECB) pumped almost US$290bn into money markets on 9-10 August in an attempt to prevent contagion from the US subprime crisis spreading further.
This came in response to the overnight rates that banks charge each other soaring. In the UK, the overnight LIBOR rate rose from 5.85% on 8 August to 6.5% today, while the overnight euro rate rose as high as 4.155%, compared with benchmark rates of 5.75% and 4% respectively.
The ECB intervention came after BNP Paribas, France’s largest bank, suspended dealing in three of its funds, worth €2bn in total, citing problems in the US subprime sector, and specifically the inability to value certain assets. Deutche Bank was similarly affected, after it said that one of its funds investing in asset-backed securities had lost almost one third of its value since the end of July.
Markets Bounce Back
Despite the sharp falls at the end of the week ending 10 August, the US market, as measured by the S&P 500 index, actually ended the week up 1.4%.
In Europe markets have recovered some of last week’s losses with the FTSE 100 index adding 139 points (2.3%) by 1pm on 13 August, as the intervention from central banks calmed markets.
Asian markets are also showing signs of recovering. The Nikkei 225 index, for example, closed up 0.2% after suffering its worst performance since March on Friday.
John Greenwood, Chief Economist of Invesco Perpetual, gave the following comment in response to the recent credit market volatility:
"There are various theories about why markets experienced such extreme volatility last week. All we know for sure is that volatility is set to continue as we see the extent of the damage from the CDO troubles and resulting credit crunch. We are taking advantage of the falls in prices of many high-quality companies, probably caused by forced sellers offloading the most liquid stocks. As long-only long-term investors, we are very relaxed about the quality of the holdings in our portfolios, which are currently biased towards cheap mega-cap stocks with good dividends and good dividend-growth prospects."
Separately Martin Walker, Fund Manager within the Henley-based UK equities team, stated:
"Conventional signals suggest that the US economy will continue growing and not face recession. Moreover, there are numerous offsets to the downturn in the housing and financial sectors, enabling the overall US economy to remain buoyant. It is still possible for a second-round deterioration in the housing market to occur with spillovers to more financial institutions. However, provided the current credit crunch does not spread to the larger global banks, then the end of the credit bubble need not spell the end of the business cycle, only the end of some of the more egregious, low yield-induced financial engineering that we have seen in recent months. If this remains the case, then the prospects for an extended US business-cycle expansion remain healthy."
Where Invesco Perpetual has expressed its own views and opinions, these may change. Invesco Perpetual is a business name of INVESCO Asset Management Limited (authorised and regulated by the Financial Services Authority).
The Rutherford Wilkinson plc View
At times like this, it reminds us of the importance of having your money invested in a well balanced portfolio in line with your comfort zone and your appetite for risk. Providing you are not reliant upon the money within the next 2-3 years, you shouldn’t panic. Of course, there is no guarantee that you will actually reclaim any apparent losses, but bear in mind that the main index, the FTSE 100, has now returned to the level it was at in September 2006.
About Ray Prince
