Tuesday, December 4, 2007

Uncertain Outlook Keeps Markets Volatile

There is a good deal of uncertainty among observers about the direction of the global economy and this is reflected in greater volatility in financial markets. Credit markets are again showing signs of fragility after the October lull, inducing central banks to lend a helping hand.

Liquidity conditions have deteriorated. Fear of defaults has increased, leading to rising swap spreads and lower prices for high-yield corporate bonds. Short-term money-market rates, such as 3-month Libor, have risen, indicating continuing tightness as lenders remain wary about lending funds to borrowers whose financial health is hard to gauge. The TED spread between 3-month Treasury bill yields and Libor remains wide. Under the circumstances, it is not surprising that the Fed and the European Central Bank have made fresh injections of liquidity into the system.

The fear is that a further drop in asset prices may lead to even tighter credit conditions. People are focusing more closely on the balance sheets of the banking system, particularly in the United States. Of course, banks in other regions aren’t being spared from scrutiny either. As everybody knows by now, globalisation of the financial system has allowed a nice distribution of toxic debt among entities all over the world.

However, many of the innovations involving derivatives related to sub-prime mortgages, originated in the United States, and American banks loaded up on the dodgy stuff more than others did, elsewhere. Yes, a lot of it is parked in Special Investment Vehicles (SIV). But, ultimately, the banks may have to take responsibility for difficult-to-sell assets that will have to be marked down considerably. HSBC, a UK-based bank, engaged in a write-down of two SIVs recently, but the American banks are still toying around with the idea of a superfund, to avoid huge write-downs.
During the past few months, several of the largest global banks, such as Citigroup, Merrill and UBS have fired their chief executives. Unfortunately, this doesn’t correct any of the mistakes of the past when these institutions took on the excessive risk. And nobody should shed a tear for the ousted executives who are paid very handsomely when they are kicked out of the door. Juicy contracts written when they were hired stipulates a hefty exit payment.

The soaring borrowing costs are a consequence of cash hoarding by banks before the end of the year. There is a general reluctance to lend unless borrowers are judged to be very safe. To alleviate the situation, central banks are injecting liquidity and extending repayment terms. This is expected to have some positive short-term effect.

But despite the proactive policies of the authorities, the risk remains, particularly in the United States, that falling asset prices, softer economic conditions and deteriorating balance sheets will force banks to tighten credit standards for consumers and corporations. This sort of credit squeeze will exacerbate an already difficult situation and increase the chances of a recession.

We have certainly not seen the end of the sub-prime fallout, and balance sheet write-downs. Naturally, investors are forward looking and seek to determine the trough for the financial services sector. However, there is still a good deal of opacity in the system, with much that is hidden and not priced properly. The travails of this sector aren’t over yet.

Recently, there was a mini-rally in the stock prices of beaten-down financials. This was less to do with judgment about rosier prospects than interest aroused because sovereign funds in the Middle East and Asia have been buying stakes in several large companies. But, these sovereign funds have very long-term investment horizons and aren’t interested in calling a bottom in the stock prices of the financial services sector.

We will hear a lot more about such funds in future years. Some of them, such as the ones in Singapore and Kuwait have been around for a long time and are experienced and well-diversified. The newer ones - - China comes to mind - - are generally poorly diversified, often heavily over-weighted in government bonds, as holdings are transferred to them from treasuries. In particular, sovereign funds in Asia and the Middle East are keen to diversify away from a substantial allocation to US fixed-income instruments.

Diversification makes a lot of sense from a simple risk management point of view. But that is not the only issue they have to handle, because political risk is also an important consideration. There are sensitivities involved, and many “strategic” sectors are considered out of bounds. Technology, defence, communications and transportation are sensitive areas. But any sector can be declared verboten by the government or the politicians. Dubai’s bid to buy a company operating ports in the US had to be dropped and China found out that purchasing an American oil company wasn’t acceptable.

Some of the money that the funds have accumulated will be run in-house and another part of it will be managed by outside entities, including hedge funds. So, not all of the money will be conservatively managed with a very long-term horizon in mind. Part of it will be managed with the goal of making short-term gains. The increase in risk appetite is not too dissimilar to the direction that pension funds and endowments have been taking in recent years.
The hedge-fund industry has recuperated quite well from the buffeting it suffered in August. The ones with good risk management and flexibility in adapting to change have bounced back. Others have fallen by the wayside. We should note that this industry normally has lots of managers entering and exiting over any given time period. A significant consequence of the August sell-off is that big funds have got bigger. It looks like large funds have attracted more money, in a sort of flight to safety.

A perennial problem for hedge funds is scalability. In other words, a given strategy that produces outstanding returns deploying $100 million may give only mediocre returns when scaled up to $500 million. Flexibility is important too. How well does a manager adapt to changing conditions? Of course, to avoid the scalability problem, some of the mega funds employ multiple strategies.
As for institutional investors, they are becoming more adept at risk management, allocating among external managers with the purpose of mixing broad directional, relative-value and special-situations strategies. Furthermore, they engage in tactical allocation within each strategy.
It also appears that, currently, small start-up hedge funds are finding it more difficult to attract money. Together with the preference for large well-established funds, this is an indication of a degree of risk aversion on the part of investors. The supply of innovative managers hasn’t dried up. It is just that receptivity is more difficult than previously.

Recent data from the US housing sector continues to paint a gloomy picture. Sales are slumping, prices are falling, foreclosures are rising, and builders are hurting. This is a sector that adjusts at a slow pace and it is more than likely that there is further adjustment to the downside.
Foreclosures are forcing more properties on the market and keeping a downward pressure on prices. And builders have plenty of unsold inventories but, unfortunately, a dearth of buyers. Just to pick one statistic, according to the S&P/Case-Schiller report, home prices in 20 metropolitan areas dropped 4.95 percent in the twelve months ending in September. This was the biggest fall since 2001, and followed a 4.31 percent drop in August.

Lending conditions are becoming more stringent for borrowers. And builders are finding that sales incentives are having a limited effect in getting buyers to walk into their offices. Naturally, potential buyers are well aware of falling prices and in many cases are willing to hold out for even bigger price declines. Then, there is the problem of teaser loans that come up for resetting next year. These are mortgages that were granted at very low rates, but will be reset at much higher rates.
There are indications that employment conditions are weakening, not substantially yet, but the trend is in that direction. Meanwhile, energy costs aren’t coming down in a hurry and the grocery bill is higher. So, American households are facing a softer job market, rising mortgage costs, high oil and food prices, tighter lending standards, and falling home prices.

That’s quite a list but, so far, there is little indication that the resilient consumer is buckling under. Retail sales during the Thanksgiving period were fairly good. However, it was also evident that retailers engaged in heavy discounting to generate sales. This is going to hurt their margins and accustom consumers to even more discounting during the Christmas shopping period. The guidance from some of the big retailers is mixed. Wal-Mart is relatively upbeat, while JC Penney and Kohl’s are somewhat gloomy.

Overall, it appears that those retailers catering to high-income consumers are doing well, but those selling to lower-income households are finding the situation more challenging. This squares with the fact that over the past five years, high-income households have benefitted far more from the growth cycle than those lower down the income scale.
Right now, the well-off may be having a few jitters about house prices and possibly worse economic prospects. But their balance sheets are still registering substantial gains in their net worth over the past several years. So they are unlikely to retrench unless conditions deteriorate. Low-income households are obviously more vulnerable.

For the household sector as a whole, adjustment in their spending/saving behaviour is likely to be relatively slow. Getting into a bit of dry theorising, we can invoke the permanent income hypothesis to explain why. The essence of the hypothesis is that choices regarding consumption patterns are determined not by current income but by longer-term income expectations.

What matters most is permanent income, not current real disposable income. An individual looks at her total assets, including property, stocks and bonds, as well as human capital based on education and experience. These assets determine her ability to earn income, and accordingly she makes an estimation of anticipated lifetime income. She will, then, seek to consume a constant proportion of this permanent income.

It is likely that because of rapid growth and a stable environment US households have upped their estimate of permanent income and it will take time for them to adjust it lower. If we are correct in judging that the US economy is now in a phase of lower productivity growth, then continuing adjustments by the household sector are likely.

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