The news seems to go from bad to worse. In late September figures showed that the American housing market was in free fall, with both sales and prices plunging. On October 1st Citigroup and UBS, two of the world’s biggest banks, said they were writing down $9.3 billion of debt between them because of the credit crunch.
Global stock markets have reacted not with dismay but with euphoria. Wall Street marked the Citigroup write-downs by driving the Dow Jones Industrial Average to a record high. The MSCI emerging-markets index has soared to new highs. This summer’s turmoil seems to have been completely forgotten.
What explains this apparent insouciance? It seems that investors reckon they cannot lose. “Take your pick,” says Gerard Minack, a strategist at Morgan Stanley: “Equity markets are either behaving as if the worst is over for credit and housing problems or they remain convinced that the [Federal Reserve] can offset whatever bad news may unfold.” In other words, bad economic news means the Fed will cut interest rates and good news means recession will be avoided.
There are some signs to support the idea that the worst might be over in the credit markets. After strenuous effort, banks have managed to find buyers for $9.4 billion of the $24 billion needed to finance the takeover of First Data, a payments processor, by Kohlberg Kravis Roberts, a private-equity firm. According to JPMorgan, even the structured products that caused so much disquiet during the summer are moving again—$6.2 billion of collateralised-debt obligations were issued in the last week of September.
Risk appetite is resurfacing in currency markets, too. The “carry trade,” the borrowing of low-yielding currencies to buy higher-yielders, is back in full swing; the Australian and New Zealand dollars have been surging. Having reached a 27-year high on October 1st, gold (often seen as a safe haven for nervous investors) suddenly lost 2.5 percent of its value in a day.
The bullish case seems fairly simple. The American economy may be slowing but the rest of the world, particularly emerging markets, can make up for it. As a result, corporate profits can continue to be strong. Profits forecasts are being revised down, but not dramatically so. Ian Scott, a strategist at Lehman Brothers, says that in America there have been just 71 profit warnings after the third quarter, compared with 114 warnings at the same stage in 2005 and 173 in 2004. The dollar’s decline has added impetus to the earnings of American exporters and multinationals with overseas subsidiaries.
In this light, the credit crunch seems like old news. Even bank write-downs can be spun in a good light. Much of the panic in August was caused by fear of what banks had on their books; now the bad news is out, investors can relax.
In addition, many investors are looking back to 1998 when the Fed cut rates in response to a previous crisis in the finance industry—the collapse of Long-Term Capital Management, a hedge fund. The markets recovered quickly and the dotcom bubble reached its apogee. This time round, emerging markets (or even alternative energy stocks) might be the big winners. And in the short term at least, money that was pouring into the credit markets is now being invested in shares.
But not everyone buys the bulls’ arguments. Experienced observers of the debt market, such as Tom Jasper of Primus Guaranty, a credit insurer, think the crunch is far from over. According to Moody’s, a rating agency, the spread (excess interest rate) of high-yield debt over Treasury bonds has fallen from the crisis peak but is far higher than it was in June.
In the quick-to-rollover money markets, there is still a much wider spread than normal between the rate governments must pay to borrow money and the rate which big banks have to pay. That indicates investors remain nervous about the extent to which banks are exposed to losses from subprime mortgages, or large private-equity borrowers.
Problems in the housing markets are far from over, too. The latest gloomy statistic to emerge was a 21.5% annual fall in pending American home sales, a figure that is a leading indicator for actual sales. House prices will surely fall further and defaults increase, as homeowners struggle to cope with higher mortgage rates from “teaser” loans taken out in 2006.
That may well have a depressing effect on consumer sentiment, something which the Fed’s rate cut last month may do little to help. Normally, interest-rate moves take 12-18 months to work their way through the economy. In any case, mortgage rates are barely lower than they were a month ago. The American economy could yet slip into recession, an event on which Goldman Sachs now places a 40% probability.
Even the argument that corporate profits are still strong does not look completely convincing. American profits are close to a 40-year high relative to national output, according to Longview Economics, a financial consultancy. That suggests they should return to the mean, especially as the profit numbers taken from national-accounts data look a lot weaker than those reported by quoted companies. The last time such a gap appeared was in the late 1990s, an era of much creative accounting.
And while the weak dollar may be good news for American exporters, it is bad for European companies. Having been strong in the early part of this year, the latest data on European economies have weakened sharply; Nicolas Sarkozy, the French president, is not the only one concerned by the euro’s strength. There is the potential for turmoil in the currency markets, either because Europe takes a stand against the rising euro at the Group of Seven finance ministers’ meeting on October 19th, or because international investors, who have to finance the American trade deficit, become alarmed by the weakness of the dollar. Stockmarkets might be able to rise above the problems of the credit markets. But whether they could gain ground in the face of foreign-exchange market turmoil as well seems a lot more doubtful.