Mischief-making behind the rumour mill SCAM

Sadly, last week events seemed to be threatening to spiral even further out of control, as rumours circulated about various US investment banks, before the UK’s HBOS came under fire. “What is genuinely terrifying for financial markets is the power of market rumour,” said Neil Dwane, CIO Europe at RCM. “The most important thing here is the speed with which this all happened…You can get talked into going bust in these financial markets.”
Regulators may suspect mischief-making behind the rumour mill, but the underlying fear that haunts the markets is of a chain reaction of defaults setting in that would see the whole banking system go down, like in the 1930s. “There’s a sense that investors have become more risk averse, and there’s a spiralling effect with that so if one set of investors gets more risk averse the price of the asset falls and that contributes to the general sense of pessimism,” says Simon Ward, chief economist at New Star Asset Management.The credit markets are not functioning particularly well – liquidity is pretty close to zero, and in the bank loan market there is a high mismatch of supply and demand due to deleveraging by hedge funds and the unwinding of SIVs and conduits. “That is putting out prices to levels that have nothing to do with the fundamentals as we are not seeing a lot of defaults,” says James Gledhill, head of fixed income at New Star Asset Management. For example, high yield debt is discounting a default peak of 10 pct, even though defaults are only at 1 pct at present. And even though the Fed has been cutting significantly for some time, the market’s expectations of further rate cuts mean that this is already factored into T-bills: “They are way ahead of where the Fed is, so rate cuts are now just psychological.” BlackRock’s Doll agrees that as equity markets won’t rally until the credit markets stabilise, this will require a sense that the Fed is finally getting ahead of the curve. But the Fed’s rate cutting is making some economists, like Ward, nervous about the impact on inflation. “The rise in energy prices is one of the reasons why the US consumer is under so much pressure,” he says. “I think they should have eased policy more gradually. They should have waited for some weakness in commodity prices and inflationary pressures more generally, and at that point they could have cut more aggressively.”
Indeed, there has been an understandable reticence from the Bank of England to cut as aggressively as the Fed as it has to focus on its inflation targets, whereas the Federal Reserve also has a mandate to consider GDP growth. “Inflation is just about to spike up because of rising commodity prices, but once we are past the oil spike we may see more aggressive rate cuts from the Bank of England,” says Toby Thompson, manager of the New Star Higher Income Fund.He suggests that equity markets seem to be expecting an early 1990s-style recession, but he doesn’t see this in the UK, arguing that different factors are at work this time round. “In the 1990s, we saw negative equity fuelled by heavy falls in house prices and significant write offs in bank lending. There were also significant commercial property write offs. It looks like the markets are expecting this again, and therefore see a big hit to banks’ earning capacity,” he says. However, he points to a big difference in the rate of debt expansion this time around as borrowings in real terms have increased by only 5 pct per annum, whereas in the run up to the 1990s recession they were up by 13 pct per annum. The biggest factor in predicting whether this will blow up in the banks’ faces is how much has been piled on at the top of the cycle, and for some analysts, the size of the buy-to-let market in the UK is a key concern. But Thompson also argues that in the 1990s, the UK house-builder market was more fragmented, and house-builders had greater levels of debt. “So they had to sell as many houses as they could to generate cash and worried less about the prices.” Now the top 10 house-builders have control of half the market and are not as significantly indebted. They have also realised that their land holdings are of value, so they prefer to reduce the numbers of houses they build if the market is soft rather than waste that value. “In the 1990s there was a greater degree of speculative build, and house-builders continued to build when the market softened,” Thompson says.
However, RCM’s Dwane strikes a more sober note: “We have to remember that in parts of Europe, particularly the UK, the biggest growth in jobs has probably been in finance and housing related industries and we need to remember that many individuals may well lose their financial firepower over the next few years.”