Markets toil and trouble

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In times of market turmoil, perspective gained from experience can be critical. As two veteran equity strategists, David Bowers and Ian Harnett can offer such a perspective. Co-founders of Absolute Strategy Research, a specialist strategy firm, they forecast very early that one of big themes for 2007 was that volatility would rise, and that the US mortgage crisis would lead to a widespread re-pricing of credit.

Mr Bowers and Mr Harnett can answer your questions on the current convulsions in markets, such as what has gone wrong, how long the turmoil will last, whether there are buying opportunities and how investors should be positioning themselves.

Your questions were answered in a live online Q&A on Monday September 3.

For many years now, we have been assured that the credit market has benefited from stability through wider dispersal of risk and therefore a shrinking likelihood of a stability-threatening collapse of one or more banks. Today, we are told that the broad spread of credit risk means that no-one knows where the risk is, creating a stability-threatening collapse of confidence in all banks. Which view do you lean towards now, and what will it take to switch your sentiment to the alternate view over the next three to six months?
Peter Krijgsman, Somerset, UK

Ian Harnett: A great question that gets to the heart of the issue. The assurances that may have been provided by some were typically issued with something of a caveat when they came from policy makers, notably, that although the risk would be spread more widely, its impact could therefore be greater if there was a major shock!

What we are now seeing is that the building blocks of the financial alchemy at the centre of the recent expansion in credit markets, mortgage backed securities, are at much greater risk than ever imagined. What is also becoming apparent is that the search for yield from investing institutions has seen many investing in products which held more financial risk than the default risk rating may have suggested.

Our view is that the scale of the problem is probably greater than generally perceived. Firstly, the underlying problem – the weakness in the US housing market - will persist for longer than many expect. We believe we are only half way through the adjustment in the US housing. This suggests further pain for the holders of sub-prime debt who will see delinquency rates rise further in the coming months. Secondly, some estimates suggest that perhaps a third of the collateral for the $2.5 trillion CDO market are sub-prime securities – this suggests that the fall-out from the sub-prime issue could be much larger than the $100bn-$300bn figures one often sees. Finally, the picture so far, of a lack of clarity about where these securitised assets are now residing means that a high level of uncertainty will persists.

So from our stance of cautiousness, we would want to see a number of things to make us more comfortable that the rise of the credit derivatives markets has mitigated these risks. Firstly, some semblance of the underlying problem appearing to be resolved. Secondly, some greater stabilization in the credit markets themselves. And finally, clarity about where the risks reside.

It is unlikely that these conditions will be met before until we have been through at least one more reporting season for the financial services companies on both sides of the Atlantic – expect a bumpy autumn.

Do the central banks and governments have the financial levers and triggers to prevent an unwinding of the leverage that has led to the lofty asset prices we have today.
E Waters, London, UK

Ian Harnett: The question presupposes that the central banks and governments want to prevent an unwinding of the leverage. There is also a question about whether such leverage has been at the root of the rise in asset prices, which I will put to one side if that is OK!

I suspect that central banks would be content to see an “orderly” de-leverage take place.

Certainly, both the financial stability reports from both the Bank of England and the ECB have highlighted that whole economy corporate debt has been rising recently, and the implication seems to be that they are somewhat concerned by this in an environment where rates are rising.

The central banks have already shown that they have a range of tools to allow liquidity to flow through the markets - it is not just a case of having to lower headline interest rates. However, in extremis, if the modest de-leveraging that they appear to prefer does impact underlying economic activity, then rates can come down. It is also the case that governments can use fiscal measures to “socialise” the cost of mitigating any de-leveraging, as happened in the S&L crisis.

In the past inflating ones way out of a debt problem has often been the response of governments that are under pressure to act!

What are the chances that a big US/UK bank will collapse due to credit crunch, SIV exposure and ABCPs issues? And will there be a crisis of confidence with the high street banks? Perhaps retail depositors do not really understand what is going on and will not notice, thereby reducing risk of such an extreme event.
Aurangzeb Bozdar, London

Ian Harnett: It is unlikely that the authorities will allow a major UK/US bank to collapse. However, the idea that at the end of this process there will be one less major player in the investment banking world is not impossible. What is more likely is that there would a merger that would see a weaker player subsumed into a stronger one.

As for the high street banks, I presume you mean in the UK. While the UK banks may have some exposure to the pressures emanating directly from the US, the real pressure would come if the UK housing market corrected in the way that it has in the US.

It seems to us (as non-specialists) that many of the techniques that were present in the sub-prime market in the US have also found there way into the UK mortgage market. A collapse of confidence in UK housing would therefore pose a much greater risk to UK banks than the aftermath of the US credit crunch.

What is an optimal structure of an investment portfolio under the high volatility conditions in the capital markets?
Viktor O Ledenyov, Ukraine

David Bowers: One of the features we have seen in recent years is the lack of differentiation between different asset classes. For example, there has been a significant convergence in credit spreads and in equity valuations (such as PE ratios). Under periods of high and increasing volatility, you would expect to see greater differentiation between and within asset classes.

Valuations start to differentiate between those companies that have genuine organic growth and those that don’t; between those companies that have strong balance sheets versus those that don’t; between the default risk of cyclical companies and that of growth stocks and sectors.

You also tend to see a re-assessment of the cost of capital. At times of low volatility, capital tends to be provided too cheaply. As volatility rises, so the cost of capital gets re-assessed.

One of our concerns this time around is that Eastern Europe has been funded off Swiss and Eurozone cost of capital, which could turn out to be too low. In our view, an optimal portfolio would be one that tries to take account of the re-appreciation of risk and the re-differentiation in valuations.

In many ways there are interesting and worrying parallels between the rise and fall of the split level investment trust market and the credit derivative markets. Would you agree that moral hazard is now more than ever a real issue and if there is again a bail-out, then the investment banks have a blank cheque from the central banks to profit at the expense of the private investor who ultimately losses out?
David G Wallace, Glasgow, Scotland

Ian Harnett: While the parallels with the split investment trusts is debatable, we would certainly feel the “moral hazard” risk is a real issue. Our view is that if even veteran investment strategists like us can work this out, then bright central bankers must be more than fully aware of the issue.

Our guess is that the central banks are keen to see a re-pricing of risk, which is why they are adding liquidity. The recent problems in the asset-backed commercial paper market highlight how central banks are keen to keep the markets functioning so that the “true” price of risk can be established. However, this type of liquidity provision is a long-way from a “bail out” of the investment banks.

As for the final part of the question, if you think that there will be a bail-out, then presumably the private investor need not lose out if they invest in the investment banks themselves!

It seems to me that the huge number of adjustable rate mortgages (ARMs) in the US that are adjusting to a higher rate over the next 12 months could be offset by aggressive Fed intervention by lowering rates to a point where these ARM’s would not set higher at all, thus making the nasty default problems go away. Seems to me the Fed has this thought in mind. What else could possibly cure this deeply rooted problem?
Thomas Hartl, Vernon Hills, Illinois

David Bowers: The key rate for US borrowers is the mortgage rate and not the Fed Funds rate. So the question is essentially how sensitive the back end of the yield curve will be to any easing by the Fed.

The so-called “Greenspan conundrum” was where long yields failed to follow the Fed’s monetary policy tightening. Our worry is that in future we may see what we have termed the “Bernanke conundrum” – where the Fed decides to cut rates but the long end fails to respond.

This could happen in a number of ways. For example, an aggressive easing by the Fed could raise inflation expectations to the detriment of the bond market. Alternatively, even if inflation expectations remain stable, real yields could stay higher for longer. We suspect that the Fed cannot ease away the forthcoming reset crisis. The problem becomes all the more difficult if the US unemployment rate starts to rise next year.

The Fed will act in a reflexive manner and cut rates, global growth is strong and inflationary pressures are not excessive. So is the market anticipating a recession that probably will not appear?
Jeremy, London

Ian Harnett: This is the “happy ever after” ending of the Goldilocks economy story that has been popular for the last few years. However, we are less sure that the outcome is likely to be so sweet.

If global growth is strong and inflationary pressures not excessive, then why would the Fed cut rates?

We think that the Fed is only likely to cut rates if they believe that there is a significant risk of recession emerging. Therefore, in our view of the world, US rates only come down once you have started to see the non-farm payroll numbers falling and unemployment beginning to rise. At that stage the Fed know for sure that inflation pressures are under control.

The other point to bear in mind is that monetary policy acts with a “long and variable lag” - a rate cut now from the Fed might help sentiment, but its real impact will only be established over a much longer period. However, the results of the rising interest rates are already apparent with slowing retail sales and a weak US housing market.

In light of the recent turmoil, do you expect Sharia’a-compliant funds (equity, sukuk or property) to gain more acceptance as an asset class especially among conventional institutional investors in western financial centres?
Ala’a Al-Yousuf, Chief Economist, Gulf Finance House, London

Ian Harnett: While not expert about Sharia’a-compliant funds, what one can see is that at a time when there is great turmoil in markets investors will seek out alternatives that provide them with more attractive risk/return characteristics.

This period of volatility will allow such Sharia’a-compliant funds an opportunity to show whether they provide just such a solution.

Some analysts have said that the major investment banks resemble extremely leveraged hedge funds (Bear Stearns has $13bn in equity supporting $400bn in assets, and Morgan Stanley’s balance sheet is at $1 trillion, etc.). Do we need to worry about all this leverage?
Donald Benson, Johannesburg, South Africa

David Bowers: In our view, financial markets have become complacent about leverage. At times of unusually low volatility, investors put in place financial structures that come under pressure once volatility begins to rise. These concerns are not limited to any one group of financial institutions.

We also think that central banks are also worried about the way that they have been disenfranchised as a result of the financial innovation seen in recent years. As they attempt to restore some control of the credit creation mechanism, we may well see some de-leveraging as unregulated financial intermediaries are brought back into the regulated environment.

There has been a lot of talk about the role of rating agencies in the current turmoil. Do you have any sense of what the medium term holds for them?
Peter Krijgsman, Somerset

Ian Harnett and David Bowers: Following the collapse of the “tech bubble” it was the investment analysts that were faced with increased regulation. Following the issues surrounding Enron, it was the accountancy companies that were pushed into the spotlight, prompting major changes in their industry.

Irrespective of the role that they have played, we suspect that by the concluding phases of the current credit market turmoil the credit rating agencies could well face increased regulatory oversight.

About the experts:

Before co-founding ASR, Mr Bowers was chief global investment strategist for Merrill Lynch where he worked for eleven years, including three in New York. He ran the firm’s Global Fund Managers’ Survey and developed it into an influential tool for understanding how investors view the world. Mr Bowers remains a consultant to Merrill Lynch on the survey. Before Merrill Lynch, Mr Bowers was chief European equity strategist at UK broker Smith New Court.

Mr Harnett was the number one ranked European equity strategist in 2003 when he headed the European Equity Strategy team for UBS. During the last 10 years Ian has also headed equity strategy teams Nat West Markets and Bankers Trust. Ian began his career as an economist; initially at the Bank of England and subsequently as group chief economist for Société Generale in London.

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