DON’T PANIC, as readers of the Hitchhiker’s Guide to the Galaxy can tell you, should always be capitalised in large friendly letters. If you happen to be holding out a thumb to passing spacecraft whilst hoping to survive on a mere thirty Altairian dollars a day it is doubtless valuable advice. DON’T PANIC also seems to be the motto that characterises the current behaviour of institutional investors.
The credit crunch has certainly provided many reasons for nervousness, around one trillion (rather than 42) according to a recent report from the International Monetary Fund. However, institutional investors have emerged from the slough of despond. For the third consecutive month the investment regime as represented by State Street Global Markets’ Regime Map is Leverage.
Whilst it is fair to say that risk-seeking is still of a different order to the gung-ho approach prior to last summer’s credit crunch, there are clear signs of improvement. Flows are selectively strong. The euro-zone has seen inflows in the upper quartile over the last month and investors also continue to buy Latin America. The euro-zone economy is proving remarkably resilient, so far, to spillover effects from the credit squeeze with German business confidence confounding expert opinion and rising again last month. Latin America, meanwhile, is benefiting from strong commodity prices.
Back in January, this shift towards more risk-seeking seemed premature. However, prices have since rewarded investors. The US S&P500 is more than 8% higher than the 52-week low it hit on 17 March and the UK FTSE100 is more than 10% higher than the nadir it hit on 22 January. Even the markets most directly damaged by the credit crisis have rallied from their all-time lows. The iTraxx Crossover index of mostly high yield European credit names is now more than 200 basis points tighter.
Though this in part may reflect technical factors due to the esoteric functioning of CDS markets, the overall tenor of markets is improving. In recent weeks, two banks have also managed to unload part of their leveraged loan books, suggesting a clearing price is at last being found for at least some of the less complex illiquid assets. The VIX index of US volatility its lowest level for four months.
The key to this change in investor behaviour has been the actions of the Federal Reserve. Throughout the credit crisis relief rallies in equity markets on news of interest rate cuts quickly ran into the sand. It seems as if the Fed was powerless in the face of distress in the financial sector and that the cycle of deleveraging would continue as banks hoarded capital and increased margin requirements. Though credit conditions are still tight, the rescue of Bear Stearns and the opening of the discount window to broker-dealers appear to have signalled a turning point for investors.
FX investors have generally been content to watch from the sidelines as their peers in the equity markets have slowly ratcheted up risk-seeking over the last few months. But even here signs are distinctly encouraging and there is more willingness to back riskier trades. The correlation between one month foreign exchange flows and high current account surplus currencies, a risk-averse trading strategy, is in negative territory for the first time in 2008.
The correlation peaked at +49% in the same week that the Federal Reserve slashed rates by 75 basis points in March. US bond yields tell a similar story. The yield on the 10-year Treasury collapsed to its lowest level since 2003 the day after the Bear Stearns rescue was announced. It has since risen, suggesting that the safe haven bid has for the time being vanished from markets.
Carry trades and buying high beta Asian stock markets are still off the agenda. But a gradual improvement in risk appetite is evident. For that, institutional investors should be thankful to the Fed. For the first time since the start of the crisis last August it seem that in turn the Fed is getting the credit for being on top of events. This mutual appreciation society will have the strength of its relationship tested in the coming months, especially if economic data worsens and it becomes clear the US is in recession. However, for the moment at least, the Fed has restored confidence and panic is in abeyance.
Michael Metcalfe is global head of macro strategy at State Street Global Markets