| Severe risk aversion to lead to increased default rates |
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| The knock-on effect of the sub-prime crisis in the US is being felt worldwide as a direct result of globalisation, says Daire Ferguson. He argues that the unrpecedented events of the current market upheaval – namely the distribution of risk throughout the market via financial innovation – could likely have further unforeseen effects on all areas of global economics. |
Vacillating from bouts of optimism to dire pessimism, markets have been in for a roller coaster ride to stomach churning proportions. Just like all financial panics in history, the problems are leverage, opacity, ignorance, greed and fear. Investors are de-leveraging and rushing for liquidity wherever they can find it. It has been a case of ‘shoot first and ask questions later’. As a result, a lot of indiscriminate forced selling has been the order of the day, affecting all asset classes from credit to equities, emerging markets and commodities.
At the heart of the crisis lie worries about the credit markets with fears that basic financing behind companies and financial institutions could be at risk, a so-called ‘credit crunch’. The origins of this route can be found in the US, where banks that provided mortgages to those with weak credit histories found they were not paid back as regularly as they expected.
Unfortunately, many of these bad mortgages were then divided into smaller lots and sold on by these banks to other investors. Once realisation of these inherent problems dawned, this swiftly led to widespread hedging of these particular assets. The ensuing meltdown in subprime, therefore, acted as a catalyst for a more widespread general unwinding of risk.
Against this backdrop, banks rapidly drew in their horns, in the process becoming a lot more cautious in their lending practices, how much they would lend and to whom. However compounding this problem further, many banks remain committed to still lending billions of dollars to companies and other institutions – previously expecting to parcel them up and sell them on to other lenders. Now, unable to shift these loans from their balance sheets, we have seen the lending wheels go into reverse. As concern about this subprime mortgage market continued to spread and market participants realised that the associated problems were not contained, sentiment nosedived across the board. Investors began to run scared, raising cash by selling any other liquid assets – shares, commodities etc fuelling the panic further.
Increasingly, the worries over excessive credit are not confined to the subprime sector – the whole of the US credit industry is looking decidedly pale. Low interest rates had translated to massive lending across the board. This wasn’t a problem when the US economy was booming but slower growth in US earnings is now provoking widespread despondency.
Added to this, there has been a systematic deterioration in credit quality as a result of financial innovation. Many investors found out the hard way that these complex structures are hard to understand, difficult to value and infrequently trade. Indeed, it is because many of these products are not required to be marked to the market in a timely manner that many market spokespeople still believe continued bad news on this front is likely to drip out. They very financial innovation which was designed to distribute risk has apparently instead broadly seen it become more concentrated – or hidden it in places not previously envisaged.
While there are many similarities in every market upheaval, these are in fact unprecedented events. We are nowhere closer to learning the extent of the credit crunch that has hit the US financial markets. Ongoing fear the America could plunge into recession and that inter-bank lending could cripple the US economy, has seen investors panic the world over as the repercussions of a potential slow-down in global growth reverberate. Selling assets is now more difficult, as anybody who has borrowed to buy money back can testify, so there is a squeeze on cash. That in a nutshell is what has been happening over the past few weeks and indeed may continue.
What does appear to be clear is that cheap credit, which has fuelled the world’s economy in recent years, has all but dried up for now. But Central Banks are fully aware of the dangers of banks withdrawing credit to the business community along the line of the 1930’s depression and have taken massive action in recent weeks to provide unlimited liquidity to avert this disaster. The Fed’s radical move to reduce the discount rate by 50 base points to 5.75 per cent was the latest action to combat financial market contagion, seeking to reassure banks not to call in credit lines and not to retreat from lending for fear of a liquidity shortage.
Of course no one knows what will happen next. Some analysts remain concerned that it is possible that the current turmoil might yet turn into a bear market. Tighter credit will mean fewer takeovers and share buybacks, which have supported shares. Clearly, deriving a strong view for credit over the next six months could be dangerous, and it certainly is a changed environment with regard to how the market views and prices risk premia. Severe risk aversion has become the order of the day and at present it is difficult to see how this won’t lead to an increase in default rates as companies’ ability to refinance themselves out of stress becomes restricted. Financial history suggests de-leveraging a financial system such as this is never easy and this often triggers nasty economic jolts.
Whether currently invested or not, the most sensible response to current market conditions is to hold fire and wait for the storm to subside. Relying on fundamental arguments remains dangerous in the very near term as investors are in a state of flux. Now is probably not the time to be selling. Further, the cost of switching and correctly retiming a re-entry into the markets is likely to mitigate any reflecting reality and the long-term outlook looks much better than the immediate cloud of uncertainty and panic suggest.
Perhaps there will be some slowdown of global growth, with some further slowing to come, but most of the current debt problems are centred on the Western world. Asia, where most of the future growth potential lies, is in robust health. If anything, a continuing strong global economy has substantially improved the longer-term outlook for many asset classes, in particular, as noted above, in emerging markets, which are less, levered and more economically sound than in the past. Provided China continues to show strong growth, much of the world’s growth prospects can remain bright – despite the ongoing jitters emanating from the US.
While by no means immune from the contagion of late, structurally strong emerging markets should begin to decouple from structurally weakening developed economies. Indeed, there is evidence that capital flows from these emerging regions could yet bail out more developed economies. Combine this with healthy balance sheets for many large firms, corporate profit outlook also remain well supported structurally.
However, once the storm is spent and equilibrium occurs, a tremendous value opportunity can be realised by those with vision, patience and sound credit discipline. Globalisation has been one of the more powerful structural changes we have observed in the world economy, and the de-leveraging we are currently witnessing will not change this. While there are areas of credit which will continue to suffer, leaving losses in their wake, it still seems unlikely that this in itself will derail world economic growth. |
Daire Ferguson is a foreign exchange dealer in capital markets with Investec.
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| Article appeared in the September 2007 issue.
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