Writing on the wall

The turmoil in the financial markets shakes the global economy to its foundations as stockmarkets tumble in the wake of dramatic events on Wall Street. Sunil Jagtiani reports from Hong Kong on the prospects for growth and recovery.

The global economy and Tstockmarket are still reeling from the financial crisis and credit squeeze triggered by the subprime imbroglio. The impact of the crisis on key American banking and mortgage firms took centre stage over the three months to September, with the travails of Fannie Mae, Freddie Mac and Lehman Brothers hogging the spotlight.

Ailing mortgage finance titans Fannie and Freddie own or guarantee about $5 trillion (£2.8 trillion) in debt and securities, which accounts for nearly half of America’s $11 trillion mortgage market. The two firms were hit by major losses following the crisis sparked by a wave of defaults on subprime, or riskier, American home loans.

In July, the American government said it would stump up as much cash as necessary to save them, but in September it took them over, pointing to a substantial risk to the financial system unless it acted (see box).

Fannie and Freddie were owned by private shareholders, even though they were chartered by the government. Hence the bailout was viewed by some as a kind of nationalisationThe two firms are crucial to the functioning of the American mortgage market, particularly the flow of new home loans, and were thought too big to fail. The government said it would buy $5 billion of their mortgage-backed securities, and inject up to $100 billion of capital into each firm.

“The government takeover of the US mortgage agencies ends the period of acute uncertainty surrounding these institutions,” says Tim Bond, the head of global asset allocation at Barclays Capital.

“Although a de facto nationalisation has always been the inevitable outcome of the crisis, the timing of such a resolution was previously unclear. As such, the actions over the weekend remove the risk that a continued policy stand-off would paralyse the availability of mortgage credit in the US.”

Meanwhile, Lehman Brothers said in September that it had suffered a $3.9 billion third-quarter net loss fuelled by massive asset write-downs. Reports said it was in talks with the state-run Korea Development Bank to raise desperately needed capital. But those negotiations later broke down.

The 158-year-old investment bank, one of Wall Street’s biggest, announced a restructuring as its shares went into freefall. But there were still concerns about whether the venerable institution could survive the crisis. A short time later it became the second major Wall Street investment bank to collapse, following the implosion at Bear Stearns in March.

The American government announced the bailout of Fannie and Freddie on September 7. The stockmarket surged worldwide the following day. But the respite from the bear market that began last year when the subprime crisis broke proved short-lived, as share prices tumbled again over the rest of that week.

The MSCI World index posted a fall of about 22% between the start of the year and September 11 (see chart, page 6). The performance of the British and continental European bourses was notably worse over the same period.

But Asian stocks suffered the most, falling nearly 35%. American and Japanese stockmarkets outperformed the world index, with America down 15% and Japan sliding 18%.

“This is a frustrating time for investors as the typical predictors of share price performance do not seem to translate into appreciating stock prices,” says James Thomson, themanager of the Rathbone Global Opportunities fund.

“Sector leadership is changing on a day-to-day basis, founded on headline news flow,” he says, adding that overall “equity markets will remain extremely volatile in the short term”.

Many analysts are still pessimistic about stockmarket prospects. They are reluctant to say that shares adequately discount economic and financial risks, or that they have become cheap enough to merit bargain-buying.

Strategists at Credit Suisse said in a recent research note that they expected the American S&P 500 index to hit a low of 1,150 to 1,200 points. At the time of writing it is at about 1,250 points.

“Our long-standing year-end target is 1,300 points for the S&P 500, but we would not recommend that clients buy equities until equities are 10% cheap against this target,” the investment bank says.

It says shares are cheap, “but not cheap enough” yet, adding the process of paring back debt following the credit crunch has “hardly started” in America.

“All of US growth in the first half of the year came from tax cuts and net exports. On the global strategy team, we believe that US growth slows to 1%, European GDP close to zero and UK GDP will contract by 1%,” the investment bank adds.

Meanwhile, Credit Suisse argues that corporate earnings were 15% above trend in Europe and 8% above trend in America, excluding resources and financial companies. But it adds that earnings “typically trough around 15% below trend and the majority of the time, equities do not trough until earnings are below trend”.

Apart from worries about the stockmarket, there are also concerns about the global economy, which has slowed in the wake of the financial crisis and a surge in inflation caused by rising energy and food costs. The International Monetary Fund expects global growth of just 3% this year (see box, page 5).

“Rather than a deep recession, we expect a prolonged period of relative economic stagnation in the industrialised world – or as in the US, mild technical recessions,” says Joachim Fels, an economist at Morgan Stanley.

“No deep recession, no vigorous recovery. With potential growth downshifting, too, and global monetary policy very easy, underlying inflation pressures should remain elevated, despite the coming decline in headline inflation,” he says.

Fels adds that the “uncomfortable mix of no growth but lingering inflation pressures severely limits central banks’ room for manoeuvre on interest rates”.

Other analysts are more optimistic about inflation. They wonder if it has peaked following a 30% slide in oil prices to about $100 a barrel from record levels above $147 hit in July. Food price hikes have also begun to weaken in many countries.

But right now the talk remains mostly of “stagflation” – slowing economic growth and high inflation. The Japanese, eurozone and British economies are generally thought to be on the verge of recession, but are also suffering from high inflation.

Official data released on September 12 showed the Japanese economy, the world’s second largest, had contracted at an annualised rate of 3% in the second quarter. Weakening exports and softening consumer spending took the blame. Inflation, meanwhile, is running at 2.4%, a level not seen for years in an economy that not so long ago was battling deflation.

“The [Japanese] economy appears to have entered a cyclical downswing, reflecting the sharp deterioration in the terms of trade and slowing global demand. With the global economy showing growing signs of weakness and the jobs market starting to soften, we expect the economy to remain on a downward slope in coming quarters,” says Kenichi Kawasaki, an economist at Lehman Brothers.

In the eurozone, GDP over the three months to June shrank 0.2% compared with the first quarter. It was the first contraction since the bloc’s creation in 1999. Inflation, meanwhile, is running at 4%, well above the European Central Bank’s target of close to, but below, 2%.

“Conditions have undoubtedly worsened considerably in recent months,” says Clemente De Lucia, an economist at BNP Paribas. “Several factors undermined eurozone activity, including the deteriorating external environment, the strength of the euro, the surge in oil and food prices, and last but not least,the tightening of monetary and credit conditions.”

De Lucia says survey data points to “further weakness in the coming months”, and predicts overall economic growth for 2008 of 1.2%, sharply lower than last year’s 2.6%.

The picture in Britain, too, is grim. House prices are tumbling and some forecasters wonder if the economy will contract over 2008. The rate of expansion fell to 1.6% in the second quarter compared with a year earlier, below the trend level of about 2.75%. But inflation is running at 4.4%, well above the Bank of England’s 2% target.

“With the UK economy likely to be in recession before the end of the year, it is tempting to suggest that the [Bank of England’s] monetary policy committee will bring rates down at the time of the next Inflation Report in November,” Investec Securities said in a recent research report.

“However, according to our forecasts the prevailing rate of inflation at that meeting [November 6] will be 5.1%, hardly the most conducive background for an easing,” the firm says, adding that it expects the Old Lady to wait until early next year before cutting interest rates.

Economic growth in the Asia-Pacific region generally is slowing too, but the area’s rate of expansion is still higher than in the industrialised world. However, there are concerns that Asia’s exports to rich countries are set to slow further.

Several Asian economies have “slowed significantly” after a year of global financial turmoil, says Sherman Chan, an analyst at Moody’s Economy.com.

“Although the outlook is far from rosy, no Asia-Pacific economies are expected to slip into recession this year – Japan and New Zealand will narrowly escape. But a sharp slowdown in GDP growth across the region is inevitable,” she says.

However, Chan adds that the performance of China and India would “remain the envy of Western countries”. Chinese expansion slowed to just over 10% in the second quarter, compared with nearly 12% over the whole of last year. India’s economic growth is running at about 8%, compared with rates above 9% last year.

But while the Chinese and Indian economies might be holding up so far despite the global slowdown, their stockmarkets are suffering. Both have crashed more than 40% this year.

Chinese investors are desperate for Beijing to launch a stimulus and stockmarket rescue package. There are rumours that an initiative worth more than $50 billion is being prepared. But Indian investors have become used to foreigners dumping local equities – some $7 billion has flowed out of Indian stocks this year, compared with an inflow of $17 billion in 2007.

Surprisingly, the one country where growth has been strong is the epicentre of the subprime crisis: America. Its economy expanded by nearly 3.3% in the second quarter compared with the same period a year ago. That was sharply higher than an annual contraction of 0.17% in the fourth quarter of 2007, and a modest expansion of 0.87% in the first three months of this year.

Analysts say a weak dollar had boosted exports, while tax rebates had encouraged spending. But both effects could soon fade. The strong growth numbers helped to trigger a big rally in the dollar in the three months to September, which could curb American export competitiveness. The stimulatory effect of the rebates, meanwhile, was always going to a temporary one.

“Credit problems are far from over,” says Leigh Skene, an economist at Lombard Street Research.

“The credit crunch is the start of the solution, not part of the problem. The problem is too much household debt, and it took the credit crunch to halt the hysterical borrowing/lending spiral.

“The crunch will be over when people understand they should be looking to repay debt, not borrow.”

Skene says that moving debt “from quasi-public balance sheets onto the federal government balance sheet not only has done nothing to repair the trashed household balance sheets that caused the credit problems in the first place, but also is “an effort to induce more mortgage borrowing.”

The end of the credit crunch, he says, would arrive only when people stop looking for it.

The Fannie Mae, Freddie Mac bailouts

The American federal takeover of the ailing mortgage finance giants Fannie Mae and Freddie Mac, which are crucial to America’s huge mortgage market, further cut the risk of their “catastrophic failure”, Deutsche Bank said in a recent research note.

It also reduced the risk of a major potential “negative feedback loop” from the financial sector to the real economy, the investment bank said.

“However, we do not see this action as a cure for all that ills the mortgage market or the financial sector more broadly,” it said, adding it did not see the mortgage market returning to normal for some time yet.

Under the takeover, the American Treasury put the so-called government-sponsored enterprises (GSEs) into a “conservatorship” under their new regulator, the Federal Housing Finance Agency.

The move came after the firms, which are owned by shareholders, were hit by big losses.

They had suffered “a period of continuing financial stress…as their stock prices plunged, the spreads (relative to Treasuries) on their pass-through debt soared and key longer-term investors began to unload their holdings of GSE securities”, Deutsche Bank said.

There are four elements to the takeover. First, the government has removed Fannie’s and Freddie’s senior management and in effect controls the firms. Second, it will also ensure that each has a positive net worth by injecting capital as necessary.

Third, the Treasury will buy mortgage-backed securities in the open market. Finally, it has created a new lending facility making credit available to Fannie and Freddie.

Deutsche Bank said that American mortgage debt totalled $11 trillion (£6.2 trillion) in the first half of 2008, and that the GSEs accounted for about 45% of outstanding mortgage assets.

Fannie and Freddie have “accounted for almost all net new mortgage financing over the past year-and-a-half”, the investment bank said.

“We conclude that the US Treasury had good reason to act given the risks that the GSEs’ problems posed for the mortgage market and the economy; its action is clearly a favorable development for the mortgage market,” Deutsche Bank said.

“The plan should bolster confidence in the GSEs and enhance their ability to sell their mortgage securities, helping to narrow spreads and the cost of home buying,” it added.

Moreover, mortgage-linked securities backed by the GSEs are also owned internationally. For example, China is said to own more than $300 billion worth. Shoring up the mortgage finance titans has helped to maintain overseas confidence in them, and in the struggling American economy.

However, other analysts have pointed out that shareholders in Fannie and Freddie lose out, as they are not covered by the bailout. Some big name fund managers could be badly hit.

International Monetary Fund view
The world economy is set to slow further in the second half of 2008 and gradually recover the following year, John Lipsky, the managing director of the International Monetary Fund (IMF), said in September.

High commodity prices and trouble in the financial markets amid the global credit squeeze following the subprime crisis were still affecting the global economy, the IMF said.

“The global economy is facing its most difficult situation in many years as we grapple with the financial crisis that erupted in August 2007, together with the impact of high commodity prices,” said Lipsky at a conference in Germany.

The unwinding of adverse effects from the sharp rise in oil prices, and a turnaround in the American housing market, should enable the world economy to recover in 2009, he said.

Oil prices were trading at about $100 a barrel at the time of writing, down from record highs above $147 hit in July.

“Looking ahead, we see commodity prices likely to stay at much higher levels than previously in real terms and highly sensitive to views about demand and supply trends,” he said.

The IMF forecasts global growth this year of about 3%, down from 5% in 2007. It predicts an annual rate of expansion of about 4% by the final three months of 2009.

Lipsky argued that robust demand in emerging economies, which have been less affected by the financial crisis, would help the recovery, but warned that their inflation rates had increased “markedly”.

There were still “elevated” risks in the financial sector, he said, whose woes were set to impede a strong economic recovery.

The IMF said banks in America and Europe had written down $500 billion (£283 billion) but raised substantial amounts of capital. For instance, some have turned to sovereign wealth funds in both Asia and the Middle East.

The IMF had originally estimated they would write down $560-$685 billion, and that the figure for the global financial system would be $1.1 trillion.

Lipsky welcomed the American government’s takeover of the ailing mortgage finance titans, Fannie Mae and Freddie Mac, which are also known as GSEs or government-sponsored enterprises.

“The intervention in the GSEs and the broader support to the mortgage market should stabilise the GSEs’ balance sheets and the funding of mortgages near-term. This will underpin the US housing market, the banking system and the broader economy,” he said.

But the managing director said it was becoming tougher to raise capital and repair balance sheets, adding banks’ lending criteria in advanced economies were set to remain tight, or were continuing to tighten.

The latter phenomenon was part of a “worrisome feedback loop” between slower growth and risk aversion leading to a reduced willingness to extend credit, the IMF said.

“A major risk, going forward, is one of significant financial deleveraging, weighing on global growth prospects for a prolonged period,” Lipsky warned.

“The financial turmoil has revealed that national financial stability frameworks have failed to keep up with financial market innovation and globalisation, at the price of deleterious cross-border spillovers,” he added.