28/08/2007
Perspectives - August 2007
How does the volatility of 2007 compare with 1998?
During the recent market turmoil, many commentators have compared events with the famous LTCM (Long Term Capital Management) debacle which erupted in the autumn of 1998. That crisis provided a good buying opportunity for equities – will history repeat itself? In this article, we show why the current situation is better in some respects, but worse in others, than the emergency nine years ago.
What were the events of 1998? After a lengthy period when Asian economies had been in trouble, pressures built up on other emerging markets. In particular, Russia announced a devaluation and debt payment moratorium on 17 August. This put pressure on the LTCM hedge fund; as its losses increased during September, many US banks were dragged into the problems, before the Fed finally lowered interest rates at month end. After two more cuts over the next six weeks, investor confidence turned around sharply, paving the way for a strong stock market into 1999.
What are the similarities between 2007 and 1998? Clearly, hedge funds are again in serious trouble, as they realise that the value of many of their assets is rather less then they thought! Distressed selling has been a noticeable feature across a range of markets as these investors have sought to cover losses elsewhere.
Investors need to be aware that history does not always repeat itself! Most notably, the 1998 crisis involved one institution, LTCM, but in 2007 the problems are spread across a multitude of firms, including hedge funds, structured investment vehicles, insurance companies, landesbanks and investment banks. Also, the world economy was rather different nine years ago. The US economy grew robustly during 1997, slowed only to trend in 1998 and accelerated again the following year. Other countries were in difficulty, with Japan and many Asian economies in recession. Now the situation is reversed: Asia is generally strong, even Europe and Japan are growing about trend, while there were worries about the housing downturn in the US causing recession even before some sources of capital began to dry up.
Another key difference is the caution of much of the corporate sector in recent years. They learnt a harsh lesson in the late 1990s, the start of a period when company balance sheets noticeably weakened, undermining their ability to resist shocks and contributing to the eventual bear market. On this occasion, profit margins are at their highest since the mid 1990s, so free cash flow, interest cover, and corporate bond defaults are all much superior. Not only are many individual companies attractive, but stock market valuations are very different now to 1998. Equities were already somewhat expensive in 1996, when Greenspan made his famous remarks about ‘irrational exuberance’, and then moved steadily into over-valued territory in the following five years. Since then, however, there has been a steady process of de-rating, with UK and US PE’s currently at their lowest since the early to mid 1990s.
Of course, some of the differences with 1998 are rather more negative. One issue is the scale of today’s problems. Likely losses on subprime mortgages alone are expected to be $100-200bn, dwarfing the $5bn loss facing LTCM, and more in common with the drawn out 1980s Savings and Loan crisis. Secondly, the solvency of sub-prime borrowers is likely to worsen, not improve, given the resetting of adjustable rate mortgages into 2008. There is more contagion now, with securitisation slicing up risk and spreading it around the global financial system. Finally, the lack of transparency about who is exposed to what has caused trust to evaporate, resulting in the many parts of the wholesale money markets seizing up. As there is no obligation on many holders of distressed assets to admit to their losses straight away, it could take some time before the full situation becomes clear.
Our analysis concludes that the differences between 1998 and 2007 more than outweigh the similarities. At a sector level, investors need to analyse the impact of a wide range of hits to financial sector earnings into 2008: higher funding costs for wholesale borrowers, compensation for investor losses, mark to market losses on investment portfolios, any rise in corporate defaults or consumer bad debts affecting commercial banks, plus lower profits for investment banks from weaker trading activity and less debt issuance or M&A activity. If these problems in the financial sector move out into the real economy, central banks will alter monetary policy, either by keeping rates on hold, or even in the US possibly cutting rates. However, if the hit to the real economy is moderate, then instead of lower interest rates a combination of money market operations and regulatory changes may be needed to improve liquidity and transparency, ultimately allowing investors to focus once again on some of the positive long term fundamentals.
Andrew Milligan, Head of Global Strategy at Standard Life Investments
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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