Large, prestigious international banks suddenly appear to be desperately short of capital amid asset write-downs and emergency fund raisings. House builders, property companies, homeowners and hedge funds are wilting under the effect of falling asset prices and rising debt finance costs, while central banks are struggling with credit markets which have, to all intents and purposes, stopped functioning. Moreover, after last week’s poor employment data, it now seems inevitable that the US will suffer a recession. As if credit crunches and economic contractions were not enough, the world economy is also suffering from record commodities prices, which are causing inflation to rise to uncomfortable levels. This unhelpful combination of circumstances has prompted journalists and other commentators to draw parallels with the 1970s, when stagflation - low growth and high inflation - caused equity markets to dive and interest rates to rocket.
Why have so many, seemingly unrelated problems all occurred simultaneously? The answer, of course, is that they are all very much related.
Let’s start with the credit crunch. It now seems certain that US interest rates were too low for too long in the early part of this century. They were below 5% for a full five years until mid-2006, and were just 1% from mid-2003 to mid-2004. These low rates coincided with a period of rapid innovation in financial products.
The two combined to make credit cheaper and more widely available than had ever been the case before. In response, consumers borrowed and went on a spending spree of unparalleled proportions, buying bigger and better houses, cars, and consumer goods in unprecedented volumes - largely from the world’s new workshop: China. Meanwhile, banks took these mortgages, car finance agreements and credit card receivables and packaged them up to satisfy the need of investors who, because of low interest rates, were tempted into more esoteric, structured products to satisfy their yield requirements.
When money is cheap and no-questions-asked loans are available to all comers, there is only one likely outcome: rising prices. US house prices rose by 50% in the 5 years to mid-2007, and elsewhere, asset price inflation was rife. Commercial property prices moved sharply higher, private equity funds bid up for buyout targets and, more recently, commodities prices have risen steeply. The offerings became more and more exotic - property in Eastern Europe, geared hedge funds, wine, art, classic cars. It is important to note, however, that exactly the same investment proposition underpinned all of these - borrow cheaply and invest for capital appreciation.
The party lasted until mid-2007 and then ended, abruptly. Rising US interest rates finally stopped house prices in their tracks and, since then, the virtuous circle has slowly but surely turned vicious. Risk assets, especially those favoured by investors capitalising on low borrowing rates, have fallen fastest, as almost overnight, the source of cheap credit evaporated.
Liquidity in markets for structured products, such as mortgage backed securities, has all but evaporated as buyers have drawn back, doubting the quality of the underlying assets. Some leveraged holders of structured products have become forced sellers, driving market prices down further.
Equities, which due to their inherent volatility were not suitable for leveraged investors, have fallen nonetheless. Expectations of slower economic growth and therefore lower company earnings have undermined prices despite equity valuations not looking extended on historic comparisons. The only safe havens for investors have been the ultra low risk asset classes - cash and government bonds - and commodities, where supply and demand constraints, along with their inflation-hedging characteristics, have kept prices moving higher.
Looking ahead
Clearly the excesses of an asset price bubble will have to work their way through the financial system. This may take longer than is currently appreciated. Assets such as US houses will have to find a floor and associated bad debts will have to be rescheduled or written off. Banks may need recapitalising and investors in highly-geared hedge funds may lose money, much as those investors in geared commercial property funds lost money last year.
The length and depth of the economic downturn will depend crucially on the path of inflation. As growth slows, demand should ease - not only for labour, resulting in higher unemployment, but also for other factors in the production process, including commodities. We consider this a powerful argument for being cautious about the outlook for many industrial commodities such as aluminium, copper and steel.
There are, no doubt, supply bottle necks which will act to prop up prices. However, fundamentally there is no shortage of these commodities and we would expect prices to fall back as economic growth slows. This, along with weaker labour markets (which should relieve upward wage pressure), should see inflation coming back under control in the coming months. This will allow the US to keep interest rates down for as long as is necessary to get the economy back onto a growth path. It should also allow central banks in the UK and continental Europe to reduce rates to ease the impact of the slowdown.
A combination of lower interest rates, government policy responses and self help will ensure that economies and financial markets recover from the current turmoil in due course. When the fog of crisis lifts, the financial world will look a little different. It seems likely that credit will be much less readily available in future. It is also likely that politicians and regulators will want to take a long, hard look at the parts played by the ratings agencies, the investment banks and some hedge funds in stoking the current crisis. More regulation and intervention seem inevitable.
Christopher Sexton, Investment Director, Saunderson House 10 March 2008