US equities outperform despite being at centre of financial crisis

If the financial crisis originated in the US, if its economy has been badly affected, if millions of its workers are unemployed, its equity markets must also be among the worst performing, right? Wrong.

Consider what has happened during the past five years. In June 2007, the rating agencies started downgrading bonds backed by subprime mortgages. In July, Countrywide Financial Corp., a large mortgage finance company in the US, warned of “difficult conditions” and investment bank Bear Stearns liquidated two hedge funds that invested in mortgage-backed securities. And in August that year, a full-fledged liquidity crisis erupted in the world’s financial markets.

It was difficult to imagine, in the initial stages, that a crisis in housing finance in the US would have more than a mild impact on emerging markets. But those dreams of decoupling were soon shattered. Nevertheless, it was reasonable to assume that since the US was the epicentre of the crash, it would be the most affected. And perhaps that would be true of its economy, if Europe had not been hobbled by what, with the benefit of hindsight, is now recognized as a severely flawed currency system.

But while the US economy has been severely damaged, its stock market has done rather well. Of course, equities have been brutally crushed all over the world and investors have suffered losses. But, considering the circumstances, the US markets haven’t done too badly. As on 1 August, the annualized return in the past five years of the MSCI US equity index was -1.09%. Contrast that with the MSCI World equity index, which had an annual return of -4.32% for the past five years. Investors in emerging markets also had a difficult time, with the annual return from MSCI Emerging Markets at -2.35%. For MSCI India, the comparable figure was -4.15%. The financial earthquake may have originated in the US, but in the markets, the periphery has been hit worse than the centre.

The returns given above are all in dollar terms. Because of the strength of the dollar, returns in local currency look better. For example, the annualized return over the past five years for MSCI Emerging Markets is -1.13%, as on 1 August, slightly worse than for the US. For MSCI India, though, returns computed in rupees give a positive figure—an annualized 2.1%, but even that is pathetic considering the inflation in the country.

In short, despite its position as chief villain responsible for the crisis rocking the world, the US market has done relatively well. And this has happened in spite of slow economic growth and a bloated fiscal deficit.

How did US equities manage to get away relatively unscathed? There are several reasons. One of them is that the health of US corporations is much better than that of the US economy. Many US companies are global and are able to take advantage of emerging market growth rates. They are also flush with cash. Another reason is the speed with which the US Federal Reserve pulled out all stops to tackle the crisis. Contrast, by way of example, the sluggishness of the European Central Bank. That is why Bill Gross, co-founder and co-chief investment officer of Pacific Investment Management Company LLC (PIMCO), the world’s largest bond investor, recently called the US the “cleanest dirty shirt”. The liquidity unleashed by the US Fed has also helped boost stocks. But the main reason for the relative buoyancy of the US markets is its position as a safe haven. In times of crisis, when risk appetite is absent and the safety of capital is paramount, big investors want large markets that have low volatility and which have depth and liquidity. The US market is by far the best on those criteria. The charm of its safe haven status in the bond markets is seen from the record low yields on its treasuries. Of course, despite doing better than most markets, the returns from US markets during the past five years have been negative. Are there any markets in the world that have given investors good returns in US dollars in the past five years? Several emerging markets fit the bill. MSCI Colombia heads the list with returns of 13.7% annualized, followed by MSCI Indonesia with 10.75%. Both these economies have been doing better than their historical trend.

The moral of the story of the last five years is you can start a global crisis and your markets can get away with it, but only if you are the US. The question is: for how long can liquidity defy the fundamentals? Keynes had the practical answer to that long ago, when he said the markets can remain irrational longer than you can remain solvent.

Manas Chakravarty looks at trends and issues in the financial markets. Comment at capitalaccount@livemint.com.

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