25/09/2007
Perspectives - September 2007
The Credit Tsunami
The past few weeks have certainly been news worthy. Central banks have carried out 180 degree turns, moving more like speed boats than super tankers. Confidence has rapidly returned to financial markets, with many stocks close to previous highs. Why do we still have niggling worries?
The recent decisions by the US Federal Reserve and the Bank of England are significant. We should not forget that only a few weeks ago Ben Bernanke was talking about inflation risks, while Andrew Sentence, one of the MPC members, argued that the UK economy was growing well above trend, possibly 3.5% a year. Nevertheless, the tightening of credit conditions over the summer was sufficiently worrying to cause the Fed to cut interest rates for the first time since mid 2003, while the UK has not only implicitly agreed to guarantee all bank deposits but also flushed the money markets with cash. It is no surprise that stock markets have recovered the major part of their August slump, trading activity has recovered significantly and measures of risk aversion are easing fast.
Information overload is a problem at times like these. Investors can get drawn too deeply into the day by day news in the financial markets, as companies report profits, hedge funds announce unexpected losses, or central banks make nuanced statements. It is necessary to stand back, and take an aerial view of proceedings. What can we see?
The answer is a credit tsunami sweeping across the landscape. The early effects were seen some months back in arcane areas of the financial markets, more recently in parts of the high street. However, there are more changes to come during 2008. Too many commentators see the US housing market and sub-prime mortgages as the cause of this tsunami. It is not; it is a symptom. The main problem is that certain parts of the credit markets experienced a period of overly easy credit expansion, or to quote Mervyn King “risk was not priced correctly”.
During a tsunami, islands and coasts are damaged one after another, depending how close they are to the original earthquake. On this occasion, we saw investment banks and hedge funds initially affected, names like BNP Paribas and Bear Stearns who could not value their holdings of complex instruments. Then large parts of the commercial banking sector came under water, when the wholesale money market froze, forcing Northern Rock to become front page news.
This is not the end of the process. Despite Fed rate cuts, US mortgage rates are higher, but just as importantly the terms and conditions attached to mortgages will tighten in most countries. This comes at a time when households in the US and the UK already face the pressure of higher mortgage payments as previously fixed deals expire.
The tsunami will sweep on. Balance sheets will increasingly matter – those with weak credit scores or poor collateral will find borrowing more difficult than will prime borrowers. Corporate bond spreads will come under pressure; we expect a sharp pick up in issuance before the end of the year, as companies and banks replace commercial paper as a major source of financing, or long delayed M&A deals like ABN Amro finally proceed. Volatility will pick up in currency markets, as investors react to different banks altering monetary policy at different times. Finally, the politicians will become involved. Several regulators are already under scrutiny for ‘being asleep at the wheel’. If a more generous deposit guarantee scheme is put into place in the UK, the authorities may try to ensure that any future liability to the industry or to the government is kept at a minimum.
Our investment philosophy at Standard Life Investments is ‘Focus on Change’. Going forwards, the key issues for investors to assess are ‘how much of this news is already in the price, and also ‘why might the market change its mind’. Here we come back again to the importance of the monetary authorities. They certainly realise the seriousness of the situation, fully intending a recession is avoided and 2008 is only another mid cycle pause. Their recent actions have already proved very fruitful, as trading returns towards more normal conditions across a range of markets and investors begin to nibble at distressed assets. Investors should not forget the much more positive state of the non-bank corporate sector than in 2000, or the favourable valuations of many assets.
It is important to emphasise that in periods of structural change, previously successful business models can sometimes stop working. The gulf between winners and losers can be sharp, as the recent divergent earnings reports from Goldman Sachs and Near Stearns showed. We believe that this is a time when deep knowledge of stock specific factors will reap dividends for active investors.
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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©2008 Standard Life Investments.
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