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When something goes wrong in the largest financial market in the world, the effects tend to ripple out to the rest of us in due course. If you are oblivious to this issue then we suggest you contact your Financial Advisor for further guidance and a review of your financial plans.
Recently, Central Banks around the world stepped in to inject liquidity to bring interbank rates in line with official targets. For the time being, such open market operations as well comforting messages from central banks that they are ready, in the words of the Federal Reserve, to "facilitate the orderly functioning of financial markets", have helped to restore some degree of stability. The federal funds rate opened at 6 percent but closed substantially below the Fed’s target after the Fed orchestrated two repos of $35 billion in mortgage-backed securities. The ECB allotted 61 billion euros in a 3 day refi tender on Friday (with a one day tender of 95 billion euros expiring, this means the ECB has drained around 34 billion euros of the funds it added) which helped bring the interbank rate back close to it target rate of 4 percent.
On the equity side, markets sold off heavily, however, because of the surge in stocks in the first half of the week, the S&P 500 still managed to close up 1.3 percent on the week while the Eurostoxx index finished nearly 2 percent lower. Expect ongoing turmoil in the equity markets spotted with rays of stabilizing hope.
Overnight, Japan Q2 GDP decelerated to +0.5% annualized, weaker than the market expectation (+0.9%). The deceleration comes after two quarters of strong growth. In China, July year-on-year (yoy) CPI inflation accelerated strongly to 5.6%, from 4.4% in June. Expect more decisive tightening measures to be implemented in the near term.
The current bout of market turmoil is stirring memories of 1998, when the global financial system was rocked by the Russian default and the implosion of Long Term Capital Management. In the wake of that turmoil, the Fed cut rates three times within the span of two months (from 5.50% to 4.75%), even going as far as making one rate cut in between meetings. This raises the question of whether something similar is happening this time around.
There are important parallels between now and then and that the lessons from 1998 can teach us a lot about what is happening in today’s environment and what may transpire in the weeks ahead. Although there are key differences, the reality is that we are seeing many of the same hallmarks as the 1998 crisis. In particular:
•Just as in 1998, credit markets have recently been roiled by the collapse of several financial companies. In 1998, the fear that a fire sale of LTCM’s derivative assets prompted the Fed, in a rare and still highly controversial move, to intervene by bringing together LTCM’s creditors to agree on terms for taking over the company. (Contrary to widespread perception, the Fed did not bail out LTCM – at no time was public money at risk; similarly, the Fed today would be inclined to bail out any institutions that are currently floundering). This time around a slew of subprime lenders have gone under and there are concerns that other institutions with subprime exposure may also be at risk.
• In 1997, the devaluation of the Thai baht caused an ever widening ripple effect, first affecting other Asian emerging markets, and then impacting Russia and Latin America. At first, the problems in Thailand were regarded as ‘home-grown’ and of little concern to the broader global economy. However, as the panic spread, the entire international financial system was engulfed. Similarly, we are now seeing the problems in U.S. subprime spread to the broader corporate credit markets, not just in the U.S. but also in Europe.
• As was the case in 1998, there is a great deal of uncertainty about how deep the problems lie and which institutions have the most exposure to nonperforming assets. Indeed, this time around, the bad assets may be much more spread out. While this is good from the perspective of risk diversification, it may also mean that workouts might be more difficult to coordinate.
• Just like in 1998, the credit markets have been racked by liquidity issues, which have caused equity markets to swoon. Swap spreads have now reached the same levels as 1998. Moreover, last week, participants in the interbank markets have become increasingly concerned about counterparty risk as well as their own liquidity needs. This has held them back from lending into the overnight market, which, in turn, has forced central banks to provide more liquidity than in any other time since 9/11.
• Just like in 1998, there has been a pronounced flight to quality, with long-term rates treasury yields declining in the face of widening credit spreads. Between mid-August and the beginning of October 1998, long-term treasury rates declined more than 100 bps. As of Friday’s close, 10 treasury yields were off about 50 bps from their June highs.
•Volatility has picked up dramatically. In terms of percentage change, the change in the VIX has already been as great as 1998.
While there are a number of striking similarities between the current environment and 1998, there are also several key differences. The most important is that the global backdrop in 2007 is quite different from 1998. For one thing, the health of emerging market economies is now much better than in 1998. By September 29, 1998, when the Fed made its first of three cuts in rates, the global economy had already been hammered by financial and economic crises across much of Asia, and in early August, by the Russian default and devaluation. As the Fed was pondering to cut rates, the crisis had already spread to Latin America and with the Japanese yen making fresh lows against the dollar, there was serious talk that China would devalue the renminbi.
How times have changed! During the most recent episode of market jitters, emerging markets have not imploded. Rather, their robust demand for exports has prevented a deeper slowdown in the US while their collective status as net creditors has helped finance the US current account deficit. Thus, emerging markets now appear to be part of the solution, and not part of the problem.
However, the strength of the emerging market economies is both a blessing and hindrance. Robust global growth has allowed the U.S. corporate earnings to stay strong despite a slowing domestic economy. However, this also means that the deflationary pressures which threatened the global economy in 1998 have been replaced with concerns about inflation, stemming in part from robust commodity demand from the EM sphere. With the Fed still concerned that inflation risks are tilted upwards, this means there is less scope to cut rates in a manner similar to 1998.
The other difference lies with the health of the U.S. economy. In many respects, the U.S. economy was on a stronger footing in 1998, and thus better able to cope with the financial fallout. The housing market was certainly a lot healthier and productivity grew at a robust pace. Today, with the housing market in dire straights and several indicators pointing to a slowdown in productivity, the resilience of the U.S. economy is more in doubt. More fundamentally, the source of the problems in the US are largely emanating from the US, whereas in 1998 they were largely emanating from the EM sphere. This suggests that while there are key differences between then and now, some of the differences make the US more vulnerable, not less so.
All this suggests that this is not the time to be complacent. Just like market participants in late 1997 and early 1998 were too quick to overlook the problems in Asia, we are not inclined to be cavalier about the risks associated with the current episode of deleveraging. However, there are also grounds for optimism. So far, we have not reached the same magnitude of market turmoil that we saw in 1998. And given the generally favorable global backdrop, healthy corporate balance sheets and strong profits across almost all developed and EM markets, there is a strong chance that the global economy will not succumb to the same extent as 1998. Couple these positive factors with ever vigilant central banks ready to inject liquidity when the need arises, and there is a good chance things will settle down and the bull market will resume its course.
Lastly, it is also worth remembering that the global economy did recover from the events of 1998. Looking back, this coincided with an impressive, albeit belated, policy response by the G7 which significantly reduced the risk of a global recession. Along with Fed easing, the $41bn package of international assistance for Brazil, a new Debt Restructuring Initiative for Asia (led by the IMF with support from the US and Japan) and a fiscal package in Japan all helped investor sentiment.
Since then, there have been a series of financial crises in Turkey and Argentina and bouts of turbulence in Brazil, none of which generated pervasive spillovers across the broader emerging market class. Moreover, the US financial system has successfully weathered the collapse of several large hedge funds and bankruptcy fears at a number of high profile companies – not to mention the attacks of September 11th. In the end, despite all the turmoil around October 1998, it proved to be a terrific buying opportunity.
The key question is whether things will get a lot worse before they get better. In the near term, this will largely hinge on whether we see any blow ups in the weeks and months ahead. The more time that goes by without a significant incident, the better. However, the constant dribble of news about who may be exposed to what is likely to keep the market on edge and volatility at elevated levels. Longer term, the issue will center on whether the repricing of risk that we are seeing will create a credit crunch that will squeeze cap ex spending and in the US, further undermine the struggling housing market.
Regardless, if you have not re-balanced your portfolio or reviewed your funds for some time, we suggest you contact us as soon as possible. |
