The butterfly effect

It may seem strange that one country's housing market woes can cause a worldwide stock market sell-off, but as this emphasises that fact that linkages in the global economy are now greater than at anytime in the past.

Certainly, a rumbling US housing market is reverberating around the world, but we believe there is no reason for investors to panic just yet.

We say 'just yet' because we believe the housing market still has some pain to endure. The impact on consumer spending and therefore on US economic growth could be greater than markets are currently pricing in.

Let's look at the cause of the recent volatility. We also believe that there are two sides to this - one economic, one emotional. The latter one is feeding on the former in our view.

First off there are the financial drivers.

For some time now, concerns have mounted about the state of the 'sub-prime' mortgage sector in the US. Sub-prime borrowers are those people with weak credit histories. Without a credit bubble assisting lax lending standards, many of these borrowers would not have been able to buy into an inflating property market during 2004 and 2005.

But buy they did and their loans were packaged and sold off to numerous buyers looking for higher yields. Hedge funds in particular invested heavily in the sector, looking to increase returns by adding leverage (debt) to the mix.

When US house prices stopped rising during 2006, and low introductory interest rates increased by several hundred basis points, many borrowers began to default on their loans. This in turn put pressure on the highly leveraged investors in the loans - mostly hedge funds.

After the collapse of the Bear Stearns (a US investment Bank) hedge funds, countless officials reassured investors that the sub-prime issues were isolated events and were nothing to worry about. (Note: take market forecasts from politicians or officials with a very large grain of salt.)

Soon after these calming words were uttered, Countrywide Financial, the largest mortgage lender in the US, warned that earnings would be weaker because a broad range of borrowers were getting behind in their loan repayments, not just sub-prime borrowers! Soon after, investors began to realise that perhaps risk had been priced too low for too long.

This renewed focus on risk has had a greater impact on stocks than the housing market itself. The increase in risk aversion has had a number of effects. The cost of 'risky' debt (anything other than government debt), has increased substantially over the last week, albeit from low levels.

Borrowing rates for companies and private equity consortiums have therefore increased, which has a big impact on the potential for debt funded takeovers. This has resulted in a fall in the share price of many perceived takeover targets.

The higher cost of borrowing has another consequence for the market. We believe the stock market is highly geared from an investor's perspective. Many individual investors, as well as hedge funds, have borrowed heavily to invest in the market. When sentiment turns, as it did last week, these highly leveraged players exacerbate the volatility by liquidating any asset to pay down their debt levels.

And the ripple is being felt globally. Australian investment bank Macquarie sparked a further sell off after warning that two debt funds could face losses of around £130 million. Last week it emerged that the German government is having to bail out large specialist lender, IKB, guaranteeing obligations of 8 billion euros.

To make matters worse for the market, inflation is still flashing as a warning sign and the Bank of England appears ready to raise interest rates again before the year is out. We believe this is likely. Indeed, we have been concerned about rising inflationary pressures in the UK for some time.

All this has resulted in a big pullback in the UK share market. Sparing very few stocks, investors took profits on the fundamentally sound resource sector and sold off banking and financial stocks on concerns that credit growth would begin to slow. Perceived takeover targets were also marked down

However a key reason why the market has been so volatile in our view is investor emotion. Fear and greed are the main emotions that rule the market. In the middle sits rationality, and this is where we try to be. In bull markets, greed has the ascendancy. Greed allows companies to trade on sky-high earnings multiples and provides the justification to make this acceptable.

But fear can grip a bull market too, as we saw yesterday and late last week. Few stocks were spared, as fear and panicked selling reigned. Investors who knew they were sitting on overpriced stocks, and even those that didn't, sold. Thankfully, we don't see those sorts of days too often.

When investors are greedy, they ignore risk, and when they are fearful, they re-price risk. The re-pricing of risk has definitely been a major theme of late. As an example of how this can impact share prices, think of a company trading on 30 times earnings. On average, this is a high earnings multiple and may be the product of too much optimism.

If fear takes hold and the company is 'de-rated' to an earnings multiple of 15 times, then the company's share price falls 50 percent without any change to earnings. So it is the change in investor perception that causes the price to fall, rather than a change in fundamentals.

There has been a huge amount of liquidity and credit creation brought about by low global interest rates over the past few years. If we can liken the increase in liquidity to a rising water level in a bathtub, then the sub-prime sector has effectively pulled the plug out.

Liquidity is drying up in these markets and this is forcing investors to sell other, more liquid assets (equities etc) to cover margin calls, repay debt and satisfy investor redemptions.

The global outlook will obviously have an impact on the local market in the months ahead, and while the outlook in the UK is for higher interest rates, in the US, official interest rates may go the other way. We believe the US housing market will continue to weaken throughout the year, putting greater pressure on highly-geared home owners and investors in mortgage debt.

Just as consumers increased their spending when house prices were rising, they are also likely to cut back when their primary asset is falling in value. Considering consumer spending accounts for 70 percent of the US economy, a consumption slowdown would likely tip the US economy into recession.

The performance of the US consumer has implications for the global economy too. Excess consumption in the US is the reason behind the country's $60 billion monthly trade deficits and $800 billion current account deficit. Paying these bills with US dollars creates a huge amount of global liquidity.

The deflationary impact that would likely ensue from a slowing housing market and weaker consumer spending would allow the Fed to lower interest rates, probably toward the end of the year. Investors appear to have priced this scenario in to some extent. Government bonds, for instance, have rallied in recent weeks and the US dollar has been very weak.

Although Fed Chairman Ben Bernanke remains vigilant on the threat of inflation, he may be fighting an old battle. If the bond market were concerned about inflation, we would not be seeing 10-year government bond yields at 4.8 percent, well below the cash rate of 5.25 percent.

In any case time will soon tell whether weakness in the US housing market will spread to the real economy and consumer spending. In the meantime, volatility is likely to remain a feature of the market for a while yet.

We believe that the sharp falls experienced last week will indeed signal the beginning of a consolidation phase. However, we expect the reporting season which is now underway will deliver solid earnings across the board, and this good news could lead to a share market rally.

In particular, we expect the resource producers to deliver strong profit growth, justifying the sharp re-rating the sector has experienced in recent months.

In our opinion, a focus on value should prove rewarding over the remainder of the year. We also recommend that investors reduce their risk by de-leveraging. Although investing with borrowed funds can be a rewarding experience when markets are moving in your favour, high volatility can destroy value very quickly. Corrections such as that seen last week serve to remind us that the market can cut both ways, and that our individual comfort levels with risk are very important.