Issue: December 2007/February 2008

Speed bump

Réjane Woodroffe, chief economist & head of international portfolios at Metropolitan Asset Managers, suggests that the credit crisis should be confined to developed markets.

Having reached new all-time highs in July, global markets seemed to hit a rather large speed bump. By mid-August, developed markets were down 11% and emerging markets had lost 16% of their value. The levels of market volatility reached in July and August had not been seen since the 1997-8 emerging market crisis the 2002-3 credit market crisis led by the collapses of Worldcom and Enron.

Prior to the latest fall-out, the International Monetary Fund had revised global economic growth expectations for 2007-8 from 4,9% to 5,2% - a significant upward revision given that annual growth averaged only 3,5% during the previous 50 years. Also significant, this upward revision was done while lowering expectations for US growth to only 2% for the year.

Yet government and corporate investment in infrastructure and human capital development, as well as buoyant consumer demand in emerging countries, have led strong global growth. Spurred by this momentum, and supported by corporate profit margins at 40-year highs (with share prices still at reasonable levels considering strong company earnings), global stock markets were driven to new peaks.

In mid-July, however, equity markets wobbled. It was sparked by fears of financial-system collapse from the over-extended US mortgage market. With the US Federal Reserve having raised interest rates steadily over the past three years, from a low of 1% in mid-2004 to 5,25%, there was widespread concern that US housing borrowers would feel pinched. It was only in July that financial markets began to price in this risk.

When corporates borrow money from the bond market, investors demand a return (“spread”) above the government’s treasury interest rate (a rate seen as risk-free as the government isn’t expect to default on its debt). Typically a large, stable company would pay a spread of 0,25 % above the Treasury bill rate. With concerns that high interest rates would begin to squeeze borrowers in the US mortgage market, during the second half of July these corporate credit spreads increased three-fold to levels not seen since the 1997-8 and 2002-3 crises.

While these concerns were justified in the low-grade sector of the US mortgage market where home-lenders extended credit to borrowers with impaired credit histories, this panic was simply not justified in the high-grade corporate sector (where balance sheets and earnings are strong), or in emerging markets (where economic growth and corporate profits are healthy). Strong recovery in the high-grade credit market since August prove that the concerns in this market were unjustified.

Emerging markets have also recovered well, gaining 34% since the low in mid- August, while developed markets are up only 12%. Strong recovery in the high-grade credit market and in emerging markets, relative to risky credit markets of the developed world, show that that the July fall-out was a problem for developed economies Negative sentiment should be contained where the problem lies.