Stockmarkets fell in January in response to economic and credit crisis concerns, stabilised in February but fell again in early March, when US non-farm payroll numbers showed a 63,000 decline, the biggest drop since March 2003. This led some to fear a US recession had begun.
Sentiment deteriorated further when Bear Stearns had to be rescued by JPMorgan Chase, backed by the Federal Reserve. Short sellers then moved their attention to other banks, including the UK’s HBOS, which denied rumours of liquidity problems.
There was a rally in late March, resulting in the MSCI World Total Return Index falling only 0.91% over the month in dollar terms but the decline was flattered by the dollar’s weakness. Emerging markets suffered badly despite further commodity price rises, with gold and oil breaking through $1,000 per ounce and $110 per barrel respectively.
Continuing the trends of recent months, government bonds rose as equities fell and the premium demanded by lenders to companies, measured by corporate bond spreads, widened further as liquidity and safety concerns increased.
Most commentators concluded that global economic growth was slowing significantly, led by the US housing market decline, which was undermining US consumer confidence. The same weakness was also becoming apparent in Europe, also due to weaker housing markets. Three questions arise. Will parts of Europe follow the US into recession? How will this affect corporate profits? And how much of this is already reflected in market prices?
Past trends can shed light on such questions. The US housing upswing started to roll over in late 2005. From that point, sales fell and prices followed sales down. With sales falling, the numbers of unsold new homes rose. In previous housing downturns, unsold stocks fell to less than seven months’ prevailing supply before the housing market bottomed.
Housing problems broke the chain’s weakest link, the sub-prime mortgage market, into which excessive leverage had been introduced. As this became evident banks hoarded cash, inflating interbank lending rates. In response, the Fed eased monetary policy and the White House cut taxes but credit markets failed to stabilise as increasing numbers of bad loans were uncovered. Each time the Fed eased, relief was only temporary.
This is important because further US housing market deterioration would have significant consequences. The 12% price drop so far has pitched about nine million households into negative equity. A further 20% fall would increase this to 30 million or a third of US households and 90% of those with mortgages. Nearly a quarter of foreclosures have occurred before painful re-financing, and jobs are only just starting to be lost. Lenders have tightened lending standards, meaning that mortgage credit has gone from being too freely available to being scarce.
The impact on consumers is that sentiment/confidence measures have dropped to levels seen in the early 1990s recession. These trends are not exclusive to the US; there are similar problems in the UK, Ireland and Spain, where house price rises have been greater.
US companies have been less depressed than consumers and the aggressive cost-cutting normally associated with deep recessions had not started in the first quarter of 2008, probably because of the strength of corporate balance sheets.
So long as most executives believe US data will stabilise then improve later this year, they should hold their nerve. But confidence is fickle and if their spirits wane, businesses could retrench more aggressively. Increased unemployment would then constrain the Fed’s ability to revive the economy.
In funding the Bear Stearns rescue, the Fed appeared to turn equity market sentiment at least temporarily because it was interpreted as putting a floor under major financial institutions. Credit markets, however, remained nervous; interbank rates remained elevated and credit spreads stayed wide. The question that follows is whether the late-March rally is a harbinger of longer-term recovery or merely a blip in a longer-term decline.
Stockmarket recoveries usually start when investors expect corporate profits to improve in the foreseeable future and analysts are starting to become more optimistic. Economic recoveries usually start after real interest rates have become negative, which is now the case in the US. Market recoveries and economic recoveries are correlated but stockmarkets often anticipate real world data. In the 1990–91 recession, equities rose before economic recovery was confirmed. The same thing happened during the 1979–80 recession.
A short-term low may, therefore, have been reached in equities although credit markets were still weak at the end of the first quarter.
In March, credit spreads implied that bond investors thought default percentages would rise into double digits, something that typically occurs only after corporate earnings fall by 25%–30% as they did in the 2000–03 bear market.
Taking this at face value, equity investors should also expect a 25%–30% earnings fall, but this was not reflected in analysts’ bottom-up earnings forecasts. So either bond investors were too pessimistic or the stockmarket was overvalued relative to the credit market. In addition, although financial sector bonds fared worse, industrial bonds were not far behind though there was little evidence of cashflow problems among industrial companies.
Lower-rated corporate bonds tend to move early in the financial cycle, recovering earlier than equities. This suggests corporate bonds are attractive, with spreads wide and appearing to discount more defaults than expected by equity investors.
Lastly, investors should distinguish between the lack of credit availability and general liquidity. An analysis of the Group of Seven’s inflation-adjusted money supply growth minus industrial output growth shows abundant liquidity. It has not, however, gone into equities and corporate bonds because of increased risk aversion. As mentioned previously, confidence is a fickle thing and can quickly turn. When it does, it may show first in the corporate bond markets.
Past performance is not necessarily a guide to future performance.
The opinions expressed here represent the views of Gregor Logan at the time of preparation and should not be interpreted as investment advice.