Analysis and exhaustive investigation of the possible impact on capital markets of the dreadful events in New York and Washington will continue for sometime. Instinctively, people have looked to past experience in order to try and reconstruct some form of order in today’s shocked environment. Comparisons have been drawn between September 11 2001 and the shocks felt after the 1962 Cuban Missile crisis, the 1990 Gulf War, or the bombing of the World Trade Centre itself in 1993. How much markets fell, how long they took to recover, what the monetary authorities did then, and what the most sensible investors should have done – all with the benefit of hindsight – in the months or years after the shocks is examined in great detail.

Central banks across the world acted quickly to cut interest rates and provide liquidity and reassurance both to the banking sectors and to the markets. Initial volatility in the stock, bond and currency markets has waned. But the tension remains palpable.
Heinz Fesser, head of international fixed income fund management at DWS Investment, describes the mood as “a heavy weight on everybody’s mind”, and confesses to feeling very emotional about the catastrophe. He stresses however that he, like everyone else, must continue to face up to his or her responsibilities. “Even in a market like this where we are all very much touched by these events,” he states, “we have to retain our professionalism and manage our clients’ assets. It is very difficult to try and strip out the emotions, but we must take care of our portfolios, it is in no-one’s interests if we were to neglect these duties.”
Prior to September 11, the team at DWS had been reasonably sanguine about the prospects for bond markets in both the US and in Europe. With little threat from inflation and continued weakness in equity markets, they felt that bonds were very well supported, even though much of the bond positive news was already priced into the market. As for the US economy, there was no real danger of it slipping into an ‘official’ recession, that is experiencing two consecutive quarters of negative growth. Fesser also argued that Bush’s tax reliefs would help to maintain the consumer sector’s stabilising influence.
Indeed, such has been the positive influence of the US consumer on the domestic economy, that without it, it has been calculated that overall G7 economic growth would have been minus 0.3% in the first half of the year. Furthermore, year-to-date equity withdrawals, from retail mortgage debt, have been adding almost 1% (annualised) to US GDP growth.
Carnegie Asset Management’s Henning Hansen admitted to some surprise at the weakness of the US economy over the summer months and said they had been downgrading the outlook for recovery. He explains: “We had seen no signs of recovery in the US, although the leading indicators such as the National Association of Purchasing Managers’ (NAPM) index had risen. In the aftermath of the attacks, we do not see that we need to change our already cautious outlook. We had already moved our portfolio duration below benchmark, incidentally for the first time in five years, and we see no reason to be moving longer at this time.”
As well as taking a bearish view on US bonds, Carnegie are also underweight European government bonds, arguing that in the short term yield may represent fair value, but that the consensus view is too bearish on the prospects of economic recovery in Europe. They expect some steepening of the curve when the European economy does begin to show signs of increased activity.
“We believe that the events in the US will clearly have an impact on the economic state, but that the turnaround will not be cancelled, only postponed. And Europe, lagging the US cycle by some five to six months, will follow, says Hansen. “Incidentally we are overweight in credit within Europe; the turnaround should eventually be good for credits. As the majority of our mandates are for the better credits, we do not look at the poorer end of the credit spectrum.”
The managers at Swiss group Clariden had, prior to the attacks, also been predicting a weaker US economy but had taken the view that bond markets would be factoring in some sort of recovery early in the New Year. “We were positioning our portfolios for a flattening of the US yield curve, and had been moving our exposure to the long end,” explains manager Martin Hueppi.
As well as lengthening duration, Hueppi had also been moving into credits. “We perceived the default rates to be peaking and this is the time to be buying spread products. Of course the terrible shocks have changed all that and credit spreads have widened dramatically.” In the immediate aftermath of the horrors, Hueppi and his team acted quickly to reduce risk by cutting their positions in the long end of the Treasury market and switching exposure into the 5-year area. “We are holding on toTreasuries because we think that liquidity is a key issue right now. I think that the TIPS (Treasury Inflation-Protected Securities) may become the instruments of choice because of the protection and their liquidity.”
Few argue that perceptions of what the economic future might hold have not been altered. Fesser at DWS believes that one has to assume that the whole world has probably been altered by the events. “Yes, we are adjusting our perceptions on the US economic recovery. Consumers, and not just in those in the US, will surely feel so much less secure and will start to save more. While we cannot sit here and accurately predict how long the slowdown will now last, I do believe that the probability of outright recession in the US is now a good deal higher, and that economic weakness globally will be longer lasting.”
Although attempting to factor in all the changes that may or indeed may not happen, DWS have not been significantly altering their portfolios in the weeks after September 11. “With the greater steepness of the US yield curve, compared to those in Europe, we had been investing in good quality non-governments and then hedging back into euros. We still see these synthetic euro investments as a good idea and will continue to hold them, and maintaining our rolling hedges.”
Hueppi is also convinced that recession looms in the US. “One assumption I am making, amidst all the uncertainty is that we will see a full blown recession. Consumer confidence must be absolutely shattered and this will drag strongly on the economy,” he says. “One thing is for sure, the capital markets have shown incredible resilience once more as indeed they did following the Russian crisis and the Long Term Credit Management debacle. The reaction to the appalling horrors of the attacks have been remarkably smooth and markets have kept going; this must be a positive sign for us all.”

In addition to his belief that US TIPS might prove to be useful investments, Hueppi has some interesting thoughts about one of the least popular investments around: corporate bonds issued by the beleaguered telecomms sector. “This sector (telecom) has been an absolute nightmare, but I have a feeling that perceptions might be altering. Take Deutsche Telekom, France Telecom and possibly even Telecom Italia – they are all utilities generating cash flow. Telephone usage will remain high, and may even increase now; mobile telephony played such a vivid role in the events in the US. Managements have been under huge pressure, especially over the summer and they know they have to deliver. I think there might be value to be had in this sector.”
Quiet caution pervades the bond investing community. For DWS’ Heinz Fesser, there is a sense that, although the nervy capital markets appear to be functioning almost as ‘normal’, the world has been significantly changed by the terrors of September 11th 2001. For their portfolios, DWS are not advocating making any huge moves within their portfolios and at the moment at least are comfortable that their bond holdings in the US – albeit hedged into euros – still constitute sound investments.
Hueppi suggests that the shock could hasten the end of the equity culture. “For those thousands of small investors sucked into the tech bubble, buying at the peak and now sitting on huge, huge losses, this latest massive shock may be the final blow that forces them to move out of equities for good, or for the rest of their lifetimes possibly. It may be good for bonds: if risk appetites are much diminished and investors become more willing to accept a much lower but much steadier income from a portfolio of corporate bonds for example, then demand for bond may be higher I am not claiming that equity returns will be bettered by bonds over the long term, I just believe that there is now a far greater possibility that the gross underperformance of bonds versus equities may be about to be reversed over the next few years.”