The economist's view

17/04/2008

Volatility continues in financial markets, and it’s a gut-wrenching time for investors. As is almost always the case, this bout of uncertainty is coming from the United States, where there are continuing signs of grief in the financial sector.

The latest casualty is Bear Stearns, an 85 year old institution about to ‘disappear’. Readers may remember that two hedge funds run by Bear Stearns got into trouble last June, when the sub-prime mortgage crisis reached a tipping point. Since then, it has been a downhill slide. In January 2007, Bear Stearns traded at US$172 a share. Around 12 March it was US$60; two days later it was close to US$30 and clearly suffering massively from funds withdrawals.

Over the following weekend, another brokerage house, JPMorgan, announced an offer to buy Bear Stearns for just $2 a share. How the mighty have fallen. The Bear Stearns building, in mid-Manhattan, is estimated to be worth about six times the value of the offer for the entire company. That a company can sink so far so fast has naturally increased concerns that there may be other ‘bodies’ from the sub-prime shipwreck about to wash up on shore.

The Fed acts

The US Federal Reserve has acted decisively. In a series of moves, it has dramatically increased the provision of liquidity to financial markets, and it has cut the Federal funds rate (the equivalent of our cash rate), by two full percentage points in just the past three months, the quickest pace of easing in more than twenty years. It also facilitated the bailout/takeover of Bear Stearns, a degree of intervention not used since the Great Depression.

On the day of the rate cut, two other financial institutions that were thought to have sub-prime related issues both reported surprisingly strong earnings and the share market had a great day, both in the United States and Australia. It’s worthwhile remembering that the only time that the US market rises by more than 3% in a single day is when the market is (still) in a declining trend, so it should have been no surprise that more than half of the day’s gains were ‘given back’ the very next day. Message: the day-to-day volatility in markets is not over yet.

The Fed’s actions have been assessed by many as treating symptoms rather than causes, and there is something to this. But the fundamental cause of the loss in value of mortgage-backed securities, which is what is behind all this, is falling house prices, and there is little the Fed can do to hold them up. Concerted action by Congress and the Administration to slow the rate of foreclosures could help, but the main reason why house prices are falling is that they just got too expensive in the first place.
Remember, too, that this is happening in an economy that has entered recession for the first time in seven years. The increasing realisation of this, and the fear that the financial crisis will make the downturn worse, caused large drops in oil, sugar and copper prices. The US dollar continues to fall but, unusually, the $A has fallen at the same time, a victim of risk aversion.

What to do?

So, what’s an investor to do? Let me say first of all that I’m not licensed to give financial advice, so what follows should not be construed as such. First, I’m sure that you wish, as I do, that you (and I) had sold out of the share market at the end of October last year. But hindsight is a wonderful thing, and that’s not the decision facing investors now. Second, as I have written before, the best assumption right now is that the volatility will continue, and that we probably haven’t yet reached the share market low.

That said, the falls have been impressive. The S&P 500 index in the US is down some 15% from its late-2007 peak, while the Australian market is off 20%, with our financial sector down by 23% at time of writing. Our financial sector is, of course, not immune from the troubles besetting world credit markets — it is ironic that the willingness to lend to all and sundry a couple of years ago has now led to a situation in which no-one wants to lend to anyone! But you just have to look at the current dividend yields for Australian banks to conclude that, barring a major accident, they are cheap right now.

If the recession in the US turns out to be mild, then share markets may not have to fall very much further for economy-wide reasons. And there are good grounds for believing that the US recession could be mild, although one can’t safely conclude that it will be until we see improvement in the functioning of the financial system.

What we do know is that, just as share markets always fall during recessions, they also bounce back strongly (beginning before the recession ends!), and investors who move to the sidelines now may avoid further short-term pain, but they may also miss the medium-term gains.

Silver lining?

Meanwhile, there is a silver lining to the cloud. The ongoing market turmoil, possible knock-on effects on the Australian economy, and some signs that the interest rate rises we’ve already had are getting some traction (consumer confidence has slumped, mortgage clearance rates are down) may cause the Reserve Bank of Australian (RBA)) to decide not to raise rates again in May after the next CPI inflation news.

The RBA will be hoping desperately for some sign in the next CPI that will at least enable it to forecast that inflation will fall back to less than 3% some time in the not-too-distant future!

More resources and reading

Investing Markets and performance
Economics: Caton's Corner Superannuation