Hiding under a quilt after the party

Investors seeking comfort at the end of a raucous party can find it in gilts, a sector that has defied the noise that hit other assets and kept its position as top performer over one year to September.

At the time of writing, the American Treasury is engaged in a genuflectory bid to get Congress to pass into law a $700 billion (£390 billion) rescue package that will, we are told, save the world from economic ruin.

That something of this kind will be enacted is hardly in doubt, but the deal will be complex, and you, dear reader, will be better placed than I am to consider the potential impact of this unprecedented intervention when it is announced. But even in these turbulent times, it is still possible to speculate on the shape of things to come.

Whatever final form it takes, the settlement will have been as much a political trade-off as an economic parachute. With their dominance in Congress, the Democrats could have wafted this measure through, despite Republican ideological objections to big meddling government and creeping “socialism”.

And there lies the rub: because it is an election year, the Democrats do not want to go to a beleaguered electorate, hostile to a fat cat bail-out, as the party that alone was responsible for putting their tax dollars on the line. Without a significant degree of Republican complaisance, this move would have to be broadly consensual, or not at all.

As part of this process, the Democrats will have wrung some concessions out of the deal. In the words of Nancy Pelosi, the House Speaker, “the party is over” for Wall Street.

And so we will see such constraints as a stringent oversight of the manner in which the Treasury manages this scheme and, more significantly, a radical overhaul of the regulatory and remuneration practices governing the banks that take to this lifeboat.

This is not a market solution – which would need to be purgative and consolidatory – but it raises some interesting questions.

The first one involves the write-downs that the banks have already stripped out of their balance sheets, and the method by which the American Treasury will value the residue of these “toxic” assets.

It is conceivable that a bank that is certain of having arrived at a realistic re-assessment will not go for a further discounted – and “strings-attached” – deal with the Treasury. Let us imagine a bi-polar world that oscillates between those institutions that run for cover (safe now), and those that eschew any kind of extraneous intervention (always safe).

The second hinges on the scope of this legislation. Are we just talking about collateralised subprime mortgages, or a wider remit? In the murky world of derivatives, it would be as well to recall the fact that many businesses raise funds through debt issuances, and that the credibility of some ratings agencies has become compromised.

In turn, this drags down the market in credit default swaps, and their insurers, whose disturbingly dubious viability offers a lurking, secondary crisis. How much more manifestation do we need of the deep interconnectedness of markets than the crumbling of AIG and the imperative nature of its resuscitation?This brings us to the key question, of where the havens are for investors. Last month I would have suggested a mixture of corporate and government bonds, but in view of the doubts expressed above there is no case remaining for commercial paper. Who can have any confidence that a bond issuer will not default on its covenants, or that – even if it is insured – the ultimate can-carrier will not collapse under the weight of its claimants?Across the western world, there will remain a lingering suspicion about any holding that carries the whiff of a derivative construct. This will also be true of any institution that declines the comfort of the lifeboat.

There is only one place to go for now, and that is gilts. Here we can take a look at how the Investment Management Association’s (IMA) UK Index Linked Gilts sector has performed over the past year, against the FTSE 100 index of major equities. The graph shows how the gilts sector has come into its own over the past year: while keeping its head above water, the flatter line also demonstrates that volatility has been mild in comparison with the alpine scenery of the equities index. Shows the total return, bid-bid, of the IMA UK Index Linked Gilts sector and the FTSE 100 index, from September 26, 2007 to September 26, 2008. Source: Financial ExpressThis is drawn from Financial Express’s data, which records that the index-linked gilt sector was both the top performer over the 12 months to September 2008 – returning 9.2% – and produced the best risk-adjusted return out of all the IMA sectors, as evidenced by an impressive Sharpe ratio of 2.16.

To put it in context, a Sharpe ratio at this level in a full-blown bull run would have the fund manager buying an estate in the Cotswolds, and cuffing peasants around the ear at breakfast time.

The whole sorry tale will be a sore disappointment to those investors who thought they had backed substantial businesses for the long term. But reality demands recognition that it is only government institutions and their effect on macroeconomic conditions that can prop up the house of cards for now.

What business can hope to raise capital, anywhere? The doom scenario of recession in the real world still hangs like Damocles’ sword over every clever incestuous idea the banks have punted out there.

Then the final question comes into play: will the American Treasury’s deal return some kind of order to the markets? Well, no. There are too many unresolved problems surrounding the extent of the fragility that has been exposed in derivative markets, the impossibility of valuing assets that no longer trade, and the lack of exit strategies.

I expect there to be a rally in financial stocks when Congress finalises its act, but the collapsing wider economies in Main Street will blast it all up in the air again. Investors can look at the graph, and decide whether to put their money, at least in the immediate term, into gilts, or under their quilts.