Markets remain a good bet in spite of high volatility
THE markets have been experiencing significant volatility as problems in the US sub-prime mortgage sector have rippled out across other countries and assets. But turmoil in the credit markets should be placed into a longer-term context.
The housing market has been an important driver for the US economy for several years, supported by strong population growth and a transformation in mortgage products. Higher interest rates finally called an end to the housing boom, with mounting weakness in terms of unsold homes, falling prices and foreclosures. This is not good news. Looking ahead, I anticipate that the housing recession will dampen US economic growth well into 2008.
There have been particular problems in the sub-prime mortgage sector. These are mortgages sold to people on relatively low incomes, often with some sort of low 'teaser' rate. As these reset, homeowners face much higher mortgage payments.
The difficulties have been compounded as many of these mortgages were packaged up into securitised bonds and then credit derivatives, complex financial instruments that allow mortgage brokers and investment banks to offset risk onto other investors such as hedge funds and insurance companies.
In the past few weeks, more investors have realised that as mortgages turn sour, the value of such products is significantly lower. The opaque nature of these transactions means that it is very uncertain what the scale of these losses has become or indeed where the losses even lie. A slump in investor confidence has caused the seizure of the wholesale commercial paper markets, where financial institutions and corporates raise short-term capital.
The central banks have aggressively injected liquidity into the money markets to restore investor confidence. As problems mounted in the money markets, the US Federal Reserve was forced to lower its discount rate - the interest rate that banks can borrow from the Fed at - in an attempt to alleviate some of these liquidity issues. The initial positive reaction from equities markets suggests the Fed may have made a good start down the road to solving the problems.
Looking ahead, there is the question of whether further action will be required. If the seizure in the money markets continues, this may result in cuts in other interest rates, such as Fed funds, the equivalent of base rates in the UK, or alternative action to improve liquidity. Meanwhile, volatile trading conditions are likely in a range of markets as distressed selling continues, carry trades are unwound and more bad news about investor losses appears.
But these difficulties have not come out of the blue. We have been aware of potential risks for some time, paying particular attention to the difficulties facing the housing market. As a result, our funds have been light in most of the affected US construction companies and we have steered clear of many of the mortgage providers that were particularly involved in the sub-prime mortgage sector.
We have generally been neutral on the investment banks, with a bias towards the quality end, reflecting their wide breadth of earnings. Our corporate bond funds have had a minimal exposure to structured credit instruments, and indeed generally steered clear of the riskier, higher-yielding bonds, preferring to invest in debt issued by more defensive and safer product and service providers. Our absolute return funds had fully hedged their credit exposure by the first quarter of the year.
Some commentators ask whether housing problems in the US could be replicated in the UK. In our opinion, the dynamics of the two housing markets are different. There has been little evidence that UK-based mortgage banks and building societies have been overly aggressive in the sorts of product that they have been selling in the last couple of years, mainly due to the watchful eye of the FSA. As long as the UK economy does slow in coming months, and there are signs that consumers are responding to earlier monetary tightening, then the Bank of England can put interest rates on hold.
We still consider the long-term prospects for equity and mainstream corporate bond markets are positive. We retain our heavy equity positions in managed portfolios as corporate profitability remains strong, balance sheets are in good order, and the global economy remains on a growth path, with flexible labour markets limiting inflation risks in most countries.
Clearly, a key risk to this scenario would be if economies slip into recession, hitting corporate profitability.
Richard Batty is global investment strategist at Standard Life Investments