Chaos in credit markets

Financial markets had been worrying about possible spill-over effects from “subprime” for some time, but the announcement in July by Bear Stearns that its two hedge funds with heavy exposure to subprime mortgages were virtually worthless was the first indication that such fears were crystallising. Meanwhile, similar reports from Germany and Australia demonstrated that, thanks to globalisation, the problem wasn’t entirely a US phenomenon. As credit spreads duly widened, fears of a full blown “credit crunch” and an end to the leveraged buyouts that had boosted equities for much of the past 12 months sent share prices around the world plunging, eliminating all previous gains made in the year to date. Consequently, after hitting an all time high of 14000 on 19 July, by 16 August the Dow Jones Industrial Average was down 8.2%. London fared even worse, with the FTSE 100 index plummeting 13.2% from the seven year high of 6732 set on 15 June to an 11 month low of 5858. Not to be outdone, between mid July and mid August, the Japanese benchmark Nikkei 225 index fell a massive 16.3%. At the same time, increasing aversion to risk saw government bond yields falling sharply, the yen (until then the main victim of the infamous carry trade) rebounding and the dollar climbing from $2.06 to $1.97 against the pound.



Having sustained such falls, the question now is where do share prices go from here? Is the recovery we have seen in the last few days a sign that normality is returning or is it merely a temporary respite ahead of further losses? Certainly there has been a marked improvement in equity market valuations in recent weeks. Indeed, helped by a sharp decline in gilt yields (down from an eight year high of 5.58% as recently as 9 July to 5.05% currently as investors have looked for safer havens) even the UK equity market, which we thought was beginning to look a bit “toppy” is once again back within our fair value range. That said, it has only just sneaked in, and any subsequent rebound in gilt yields, which is likely if the equity market stability of the last few days is maintained, will push it back out again. However, further out, there is value to be had with gilt yields likely (in our view) to fall significantly in 2008 as inflation continues to surprise on the downside and the MPC begins to lower interest rates. Meanwhile, absolute valuations have fallen dramatically, with the trailing earnings multiple on the FTSE All Share Index falling to a 16 year low of just over 12 times.

But whilst valuations have clearly improved, is it possible that equities might become even cheaper in the near term? The big unknown is the extent to which recent events will constrain the growth in the global economy in the year ahead, possibly even driving it (or parts of it) into recession. If they do, then by definition corporate earnings and therefore equity prices will be lower than would otherwise be the case. What we do know, however, and confirmed in a statement last week, is that the Federal Reserve will do anything to prevent the problems in the credit markets from damaging the prospects for the real economy. If this means setting its recent concerns about inflation to one side for the time being then so be it. Until the present crisis, US interest rates looked to be on hold until early next year, but increasingly it looks as though the first cut will be brought forward to September (when the FOMC next meets) or possibly even before. This will provide substantial support for equities; indeed the growing expectation of such a move largely explains why equity markets have enjoyed a period of relative calm over the last few days.

Meanwhile, whilst the European Central Bank has been prepared to provide emergency funding to the credit markets, remarks from central bank president Jean-Claude Trichet yesterday suggest the ECB is likely to press ahead with an interest rate increase in September. Similarly, Bank of England Governor Mervyn King appeared to be talking tough when he said that it wasn’t “the role of monetary policy to protect irresponsible lenders from the consequences of their actions”. However, subsequent to this, the minutes of the August MPC meeting, at which interest rates were held at 5.75% by a unanimous decision, raised the prospect that UK interest rates may already have peaked. Although the central inflation projection in the August Bank of England Inflation Report had shown inflation hitting its 2% target in two years’ time only if interest rates were raised a further quarter-point, the minutes revealed that most of the Committee members “had no firm view on whether rates would need to rise further”. And with inflation unexpectedly falling to 1.9% in July, the chances of that being it in terms of policy tightening must surely have increased further. If this indeed turns out to be the case, then this will clearly be excellent news for equities and gilts alike.

So is this a buying opportunity or not? Longer-term investors who are prepared to ride out the present period of volatility should certainly view it as such. We don’t believe the global economy is heading for recession and in fact the Federal Reserve has already stated that it “will use all instruments in its possession” to ensure that it is avoided. Corporate earnings growth, whilst slowing, continues to surprise on the upside and should actually be enhanced by the lower interest rate environment that now looks likely. At the same time, (non-UK) equity market valuations are on the cheap side of fair value. However, for those who are unwilling to contemplate further losses in the short term, a more prudent approach would be to monitor the situation closely for signs of contagion between the credit markets and the real economy. The one thing we don’t believe we are witnessing is the start of a new secular bear market.