Overview: The Shell Game

The extreme volatility across the various markets is similar to the blur of hands that accompany a shell game. Although onlookers try to stay abreast of the situation, the rate of change is so fast that they become disorientated and fail to keep up. The markets appear erratic, defying fundamental conditions and logic. Many people complain about the disconnect between the equity and fixed income markets. While the U.S. and European corporate bond markets are in freefall, the equity markets are sanguine. A look at European iTraxx credit index shows a steady widening of bond spreads, with no end in sight. A similar situation exists in the U.S. high yield bond market. In fact, there are 363 U.S. high yield bond issues, totaling $132 billion in face value, trading at distressed levels-which is defined as a spread of more than 1,000 bps over Treasuries. There were only 22 distressed U.S. bond issues last July. This was a 15-fold increase in the space of only 7 months. One would have thought that such carnage would have been better reflected in the U.S. equity market. However, the reaction was muted. Many analysts attribute this to decoupling. However, a better explanation is displacement.

In the same way that the passengers on the Titanic congregated at the stern as the bow slipped below the icy waves, investors are seeking the relative safety of the equity markets. However, there are signs that they will soon suffer. Thomson Financial recently reported that almost two-thirds of the equity deals that were scheduled for the first two months of this year were cancelled. Only $13 billion in equity financing was completed. The good news was that most (85%) of the completed IPOs were in emerging market countries. Although the equity indices are not plunging, it is clear that investors are becoming much more risk adverse. The epicenter of the crisis may be in the bond markets, but the evidence shows that the equity markets are also feeling the after-effects of greater risk aversion. This means that the relative safety of the equity markets will eventually fade.

Central bankers hope that the commercial banks can fill the gaps created by the turmoil in the capital markets, but they lack the human resources and institutional capacity to do so. The Fed and ECB are encouraging commercial banks to step up lending activity in return for easy access to liquidity windows. However, most commercial banks gutted their credit departments during the 1990s, as they incorporated the new Basle norms. Given the importance of credit-rated instruments in the Basle framework, most commercial banks eschewed direct lending. Instead, they loaded their balance sheets with derivates and other credit rated-assets, thus allowing them to reduce their staff and improve their profit margins. Armies of credit analysts and loan officers, with decades of experience, were replaced by handfuls of mathematicians and statisticians who could not differentiate between an income statement and balance sheet, but could calculate covariance and correlation matrices. The analysis process was outsourced to the credit rating agencies, institutions whose interests were not aligned with the shareholders and depositors of the banks. The former only wanted to get deals done, while the latter wanted to protect their capital. Some people think that the situation can be changed overnight. They take solace that bank lending in Europe was up 14% last year. However, the increase was from a very low base, and it was nowhere near enough to compensate for the closure of the capital markets. Commercial banks will need to rebuild their credit departments, which will take time and money. In the meantime, the corporate sector will have to deleverage.

The loss of credit and equity financing in the U.S. and Europe will soon depress economic activity. Many companies are already warning shareholders that performance is starting to suffer. Companies are shelving expansion plans, and others are hoarding cash in order to meet financial obligations. Unfortunately, these problems will have a major impact on global demand. The U.S. and Europe represent almost half of global GDP-although they represent only 10% of the world’s population. This means that a global slowdown is inevitable. In the meantime, capital will desperately seek safety across the various markets that appear to be on higher ground, thus creating the illusion and hope of safety and decoupling. This is why investors need to keep a close eye on the ball. Otherwise, they may find themselves empty handed.

One Response to "Overview: The Shell Game"

  1. Guest   February 29, 2008 at 2:14 pm

    True, indeed; but if you go through the financial page of any Latin newspaper you’ll see that they bought the ‘decouple’ thesis, and are living in go-go land. Until you realize (by way of their analyses, or lack thereof) that it is just plain ignorance this commodities-based euphoria. Uh, the fools!