An Eventful January

February 2008 Malcolm Thomas

Five long weeks have passed since our last Newsletter – a period that will doubtless be remembered well by many market observers, characterised as it was by enormous volatility, a series of major policy and economic developments, US monoline insurance scares and yet another wave of huge credit write-downs by several of the world’s largest financial companies. In addition, participants were again exposed to the discovery of a “rogue trader” at a European bank, but this time of unprecedented dimension. And while net currency changes were perhaps not as crazy as some would have expected given the pace of events – and commodities appeared for the most part strangely unmoved outside precious metals – other markets experienced wild swings. Indeed the combination of recessionary worries, resurgent fears over the integrity of the global financial system and aggressive monetary easing by the Fed proved a potent mixture for both bonds and equities. On the positive side, the initial panic early in the January 21st week – which almost brought about a collapse in world equities – was not sustained, with markets (helped by Fed action) instead staging reasonable recoveries over subsequent sessions. But these also failed to claw back the damage suffered since the end of 2007 and in the end, January, on net, turned out to be a great month for G7 government bonds but a terrible one for stocks and high yield issues. Spreads on the latter continued to widen alarmingly while all major equity indices experienced large declines with many – like the European DJ STOXX 600 & the Japanese NIKKEI – confirmed as being “officially” in bear markets (off 20%+ from their 2007 highs). In fact, January was the weakest month since 2001 for the MSCI Asia-Pacific index and the worst for the US S&P 500 in 18 years.

However, stepping away from all the day-to-day excitement, there were also some crucial fundamental developments well worth noting, whose impact over the balance of 2008 is likely to be profound. Many surround the response of the G7 Central Banks to what clearly was a dangerous crisis in markets, a crisis triggered by a gradual realisation that the global credit problems were considerably greater than thought and that the broad economic outlook was thus probably much worse than expected. But while the Fed decided to move aggressively, in fact acting in such a manner that smacked to some of outright panic, there were no similar moves by any other major Central Bank – indeed apart from a tiny 0.25% rate cut in Canada, there was NO significant policy action at all outside the US last month. What should one make of this? It is of course tempting to take a cynical view, surmising that with stocks opening the New Year in complete disarray and Wall Street under intense pressure, the Fed was totally absorbed by the potential for a 1987-style crash and effectively succumbed to the market’s force majeure, cutting policy rates by a huge 0.75% when they possibly could have waited for a week when the formal FOMC meeting was due. In this regard, whether the unwinding of the $75b in long positions amassed by the Societe Generale rogue trader (which now looks to have triggered those massive equity declines in Europe on the Martin Luther King US holiday) unwittingly influenced the Fed’s emergency decision to cut rates the following day is not known. But to many the suspicion is that it was a key factor, implying that the so-called Greenspan Put (where the Fed was always expected to come to the rescue of Wall Street as in 1987 & 1998 and other instances) is finding new life with Mr Bernanke. So the FOMC panicked, but other G7 Banks saw the issue as a market problem that was not serious enough to have major policy implications – particularly if they were to compromise the inflation focus of some, like the ECB. For our part however we think that this conclusion, while partly correct, was actually not the main reason why the Fed elected to ease so aggressively – cutting rates not once, but twice in the spate of just 8 days for a cumulative Fed Funds reduction of 1.25% (thus bringing their main policy rate back to where it was in June 2005 and down a total 2.25% from the level pertaining last September). For although market turbulence undoubtedly played its part, the Fed’s principal concerns remain the risk to the banking system and the economy, threats that were believed containable only last October/early November after their policy actions in August/September. But with the benefit of hindsight it seems pretty obvious that the FOMC (along with the US Treasury) grossly underestimated not only the still-unfolding credit problems, but also the rate at which the economy was slowing. Before this January, while the Fed certainly appeared worried about the housing debacle, most official commentary suggested the FOMC considered it still manageable and unlikely to precipitate a recession, with the predominant view remaining that the difficulties would work their way out during 2008 with help from the Paulson initiative and marginally lower interest rates. And along with this misjudgement, the Fed also appears to have miscalculated the impact housing was starting to have on consumer spending (especially at a time when energy prices were soaring) as well as the adverse effect of weaker corporate profits, which at some point stood to seriously damage the labour market by curtailing hiring, thus removing another major support for spending. It will be remembered that the Fed’s latest Beige Book – although acknowledging that the economy was indeed slowing – was not especially alarmist at the time, and also described the labour market as still “tight” in many areas (the FOMC has come to rely heavily on the timely anecdotal evidence supplied in this report compiled within the Fed system). This particular compendium of national activity now appears to have reached quite incorrect conclusions.

Thus it must have come as quite a shock to Mr Bernanke and his associates when the December Employment data showed the private sector actually shedding jobs and the ISM survey indicating that manufacturing (which should have been benefitting from export growth) was contracting. On top of this, it began to dawn on officials that far from improving, the credit crisis was worsening again, despite massive short-term liquidity injections through the Fed’s new Term Auction Facility (TAF) programme. Instead, although the seizure in the short-term money markets appeared to have ended with these interventions, market-driven longer-term spreads continued to widen and vast areas of the asset-backed & derivative markets were not functioning. For instance, the CDO (Collateralized Debt Obligation) has remained closed since end-December, as effectively has the LBO (Leveraged Buyout) market – thus leaving many banks in the lurch – at the same time as fears over the scale of potential credit losses have escalated dramatically following the Citigroup & Merrill write-down announcements, both of which succeeded in easily eclipsing the most pessimistic estimates. Add to this the precarious position of the monoline insurers that guarantee some $2.4 trillion in debt (including almost $1tr in structured) and the Fed was suddenly confronted with yet another threat to the financial system, this for the third time in just five months. And then, with credit standards tightening, the Philadelphia Fed reported that its national survey found that a majority of US States were experiencing a contraction in economic activity for the first time in years, a relatively rare event that has historically been accurate at heralding recession. Therefore, with the severe weakness of Wall Street also serving to undermine hopes that housing-related declines in household wealth would be partially offset by higher equities, it became clear that the economic outlook was in far more perilous shape than believed before.

In this case, even if one accepts that the Fed acted as it did for “proper” reasons and essentially to meet both economic & systemic threats of severe magnitude, why then did other G7 Central Banks not follow? Given that economic activity was and is slowing significantly across the developed world while the credit crisis continues to menace European banks as much as US institutions, a co-ordinated response would have sent a stronger message and laid the groundwork for a much quicker economic response than the Fed moving alone. This did not occur, and one is compelled to conclude that other Central Banks and especially the ECB are much less worried than the Fed over the economic and credit risks that are overshadowing the outlook for global activity, instead focusing on current inflation pressures.

For our part, we instead remain extremely concerned over the scope and ultimate ramifications of the crisis and the associated risks to G7 growth. A recent close examination of the amount of securities and derivative structures “at risk” of write-down should the US fall into a mild downturn suggests the potential exposure is far higher than widely believed, especially when counterparty risk in the $50+ trillion Credit Default Swap market is included. Note too that much conventional analysis only focuses on US mortgage debt-related instruments; with the commercial and housing markets in parts of Europe now showing signs of deterioration, it would be logical to expect some fallout in the $1.2 trillion European asset-backed sector as well (30% of which, for instance, is underpinned by Spanish real estate). So with the global credit situation still very shaky amidst a rapidly softening economic background, we think the “hands off” approach currently taken by other G7 Central Banks risks turning out to be a (global) policy error. Let us hope that this will change sooner rather than later.