The markets have been in the grip of a panic this week, with stocks plummeting, crude oil prices staying above $100 (Rs4,050) a barrel and the dollar plumbing new depths. In spite of a series of rate cuts by the US Federal Reserve and the injection of billions of dollars in liquidity, credit spreads remain at elevated levels. Banks are calling in loans, and hedge funds, unable to meet margin calls, are collapsing. And the news from the US economy keeps getting worse.
A credit crisis of this magnitude is unprecedented, far worse than the crisis caused by the Russian default and the Long Term Capital Management (LTCM) meltdown a decade ago. But market experts have been trying to make sense of the crisis and trying to get some idea of the future direction of the markets by going back to the past.
What has been the historical connection between the credit markets and equities? Do they move in tandem or does one lead the other? How long do such crises last? These are some of the big questions that investors are asking, and equity strategists are attempting to answer.
A recent Citigroup research note on equity strategy (Global Equity Strategist, “Testing the Bull” ) identifies the four phases of the credit cycle. In the first stage, profits are low and corporate balance sheets are being repaired, as in 2002-03. That’s the time when credit markets do well, but equities are lacklustre.
The next phase begins when profits start to look up and stock prices start rallying. Balance sheets, too, are in good shape. That’s the time to go long in both credit markets, as well as equities. In the current cycle this phase lasted from 2003-07.
In phase III, balance sheets worsen, spreads rise and volatility increases. During this stage, say the Citi strategists, “the equity market eventually decouples from the credit and continues to rise. This is the mature equity bull market.”
And the fourth stage is when balance sheets contract, profits fall, credit ratings worsen and equity and credit prices fall together.
The question is: Are we in phase III or phase IV? At the moment, both equity and credit markets have been plunging together, so it does seem as if we’re in a bear market, rather than the “mature bull” market predicted by the Citi strategists. But the note points to two earlier instances when there was a decoupling between the equity and credit markets.
One of them occurred after the 1987 stock market crash in the US, when the Fed cut rates and equities recovered to make new highs, but credit markets continued to decline. The other precedent was in 1998, when global equities sold off 22% between July and October before rate cuts by the Fed saved the day and led to a rally in stocks, although credit markets continued to be jittery and yields continued to rise.
The Citi analysts conclude: “So, perhaps, the current turmoil in financial markets is not as unprecedented as it may feel. The rise in credit spreads and the fall in the global equity market are similar to 1998. The fall in the equity market is actually less than that seen in 1987. Both were classic bull market corrections. Perhaps that is what we are going through right now.”
That’s not the only bullish conclusion.
The Citi note also says that even if earnings fall, as a result of the US recession, it is possible for share prices to rise. For instance, during the Asian crisis, earnings per share for the MSCI World Index fell by 15% from late 1998 to late 1999, but stock prices rose by 25%.
The moot question is whether the current carnage in the credit markets can be compared with earlier periods of turmoil, or whether it is much bigger.
The problem is that the derivative markets have become huge and a long period of very low interest rates has led to excessive leverage. For instance, Carlyle Capital, the fund that collapsed recently, had a leverage of 32 times. This phenomenal growth in leverage over the last few years, aided and abetted by derivatives, means that the impact of the current crisis is likely to be far deeper and more prolonged than previous instances of credit turmoil. The leverage used to be a great source of liquidity to the stock markets, which is why its withdrawal has led to such severe repercussions.
Nevertheless, according to the Citi note, global excess liquidity (measured by global M3 growth less nominal GDP) is still abundant, with money supply growing in excess of economic demand by a significant 3.3% a year. The trouble is that this liquidity is now going into commodities, into gold and US treasuries and money market funds.
So, what do the Citi analysts conclude? They say the cheap money never seems to go back to the asset class that was the original source of the problem.
Just as real estate benefited from the equity woes of the early years of this decade, maybe the money will go into equities and into emerging markets, where there’s growth. They accordingly recommend an overweight in emerging markets and the materials sector.
But, it is very likely they may have under-emphasized the importance of leverage.
The bottom line is that debt levels are sustainable as long as there’s the income to service the debt and to repay it. No amount of liquidity can ensure that.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at email@example.com