Was this market volatility caused by senior investment managers heading to the beach, leaving inexperienced and panicky juniors in control, or has there been a more fundamental change?
Many investors are taking their cue from the turmoil surrounding the near collapse of Long-Term Capital Management (LTCM) hedge fund in 1998. Then, the sudden rate cuts from the Federal Reserve enabled a rapid return to more normal market circumstances, helping investors focus once again on the robust (and inflationless) growth of the economy.
An important reason why events following the policy easing in 1998 might not be repeated, is the difference in attitude of policymakers. Then, still affected by the aftermath of the Asian financial crisis, the response of the Fed under Alan Greenspan to the implosion at LTCM was to cut interest rates, although there was little sign of a broader economic impact.
For the first time since the “Saturday night massacre” when the then Fed chairman, Paul Volker, tightened monetary policy on October 6, 1979, this indicated that controlling inflation was not the be-all and end-all for American monetary policy.
Despite accusations that the aggressive 50 basis points cuts to both the Fed funds target and discount rates reinstates the Fed put for investors, central bankers on both sides of the Atlantic are keen to avoid the creation of moral hazard and the Fed retained its anti-inflation bias in its latest statement.
Another distinction is the likely change in the availability of credit as fund flows into leveraged investments slow down. Where the bail-out of LTCM and the collapse of the Nasdaq index post-2000 proved to be positive adverts for structured investments, the evaporation of market liquidity and opacity of true market values in events this summer will lead investors to question the appropriateness of these “lower risk” investment approaches.
Together, with the need for banks to bring the off-balance sheet conduits and Structured Investment Vehicles (Sivs) back onto their balance sheets, the deleveraging of the financial system could prove significant.
While wishing to borrow the caveat adopted by Mervyn King, the governor of the Bank of England, in his letter to the Treasury Select Committee on September 12 that any observation is a little like “taking a snapshot of a fast moving situation with a long exposure camera,” several longer term observations can be made:
- Although a financial crisis is by definition unexpected, it should be no surprise that one should arrive after interest rates have been increased (in America since 2004). The end of a period of interest rate increases, and the move to ease policy has usually been signalled by such an event.
- Equally, while the media will continue to dig up more examples of the excesses of the past cycle, the policy response will eventually be enough to kick-start a return to more normal conditions – as America’s Treasury Secretary, Hank Paulson, indicated in Berlin on September 11, the global nature of this crisis may mean that this takes some time.
- The visible, if sometimes uncomfortable, volatility of equity markets is likely to become a desirable attribute for investors. At least compensaShows Federal Reserve target rate in percentage terms from 1968 to September 19, 2007. Source: Datastreamtion for the short-term risk makes it clear why equities produce superior long-term returns. The same cannot be said for many of the opaque, illiquid “low risk” alternative approaches that have been the focus of the turmoil this summer.
- Economy and earnings growth is likely to be slower than it was before these events. Even the Bank of England is not making the case that there will be no economic impact from recent financial events.
This suggests that companies that are able to deliver consistent earnings growth, regardless of economic and financial market events are likely to perform relatively well.
Indeed, given the compression of valuations within the market as investors have priced an outlook devoid of a business cycle, these are the areas that are arguably also cheap and hence offer significant investment potential.
- The availability of debt financing and the terms on which this is available are likely to have been permanently impaired. This means that the private equity bid that has underpinned some parts of equity markets is much weaker. Equally, business models/expected returns that rely on access to debt markets will perform less well than they have done.
- Despite the apparently cheap valuation of the bank sector (according to Datastream the American bank sector trades on a dividend yield of 4%, 2.5 times the market yield) and the likelihood of further rate cuts by the Fed, the uncertainty over revenue growth and the greater visibility of the riskiness of bank business models suggests that a cautious approach to investment in this space remains appropriate.