In ‘Much Ado About Nothing’, William Shakepseare describes a February face as “full of frost, of storm and cloudiness”. The turning of the year has certainly done little to lift the mood of institutional investors. After briefly warming to risky assets at the end of 2008, 2009 has begun with an implacable chill. The investment regime is once more at riot point, the most risk averse of the five gradations of investor confidence anatomised by the Regime Map (figure 1). The cautious behaviour that characterised much of the second half of last year is once more to the fore.
There are numerous possible explanations for this rapid reversal in risk appetite. From a tactical standpoint the short-lived move into equities by institutional investors has been rewarded. Stock markets in the developed world enjoyed a 20% rally between their November lows and early January. Emerging markets fared even better; the MSCI Emerging Markets Index rose 30%. The sectors that took the worst of the battering last autumn, such as metals and mining, have performed spectacularly.
The new year has prompted pause for thought. Fear of missing the upturn has given way to fear of losing money. Although it is often the case that the turn in the stock market leads a recovery in the real economy by several quarters, it is hard to ignore the barrage of bad news. Since the beginning of the credit crunch in August 2007 optimists have had their hopes dashed. It seems a long time ago, but the markets peaked in October that year following the decision of the Federal Reserve to cut interest rates by 50bp at its September meeting.
In those innocent days many assumed that the usual policy prescription of cutting rates (and steepening the yield curve) would both revive the economy and inject liquidity back into the banking system. Nine rate cuts later, with policy officially at zero, the US economy shows little sign of an imminent recovery. Conventional policy measures are not working. The Federal Reserve more than tripled the size of its balance sheet to close to $3trn in the final quarter of 2008 in an attempt to ease monetary policy further. Only time will tell whether unconventional tools such as quantitative easing will work, but necessity is the mother of invention.
That need is abundantly clear. The US job market has just endured its worst year since 1945. The recession that began in January 2008 is set to be deeper and more enduring than the typical post-war cyclical downturn. Nor has the rest of the world been immune. Even when the Federal Reserve was forced into an emergency rate cut last January, many still held on to the quaint notion that a large part of the global economy could decouple from a slowing US. The US might sneeze, but the BRICs and other more virile economies could resist the contagion.
The global economy is now collectively bedridden. Growth forecasts for 2009 have been ratcheted down. Nowhere is the collateral damage clearer than in Germany, the biggest economy in the euro-zone. The world’s largest merchandise exporter had driven European growth. But the capitulation of the US consumer has hit auto exports, and orders for machine tools from the factories of the developing world have dried up. In November, German exports saw their sharpest monthly drop since 1969. Forecasters believe output will fall 2% this year.
With the mine of monetary policy almost exhausted, the latest policy prescription is a massive dose of Keynesianism. US president Barack Obama looks set to ink an $800bn fiscal stimulus package, a sum close to 5% of US GDP. It might work. However, institutional investors are right to raise a sceptical eyebrow. The current malaise was once dubbed a credit crisis. In truth it has always been a solvency crisis.
Insolvent borrowers should have never been offered credit to buy homes with inflated price tags. When the value of those houses fell it was not just the (former) homeowners who were in trouble but the lenders and those banks and investors who had bought MBS (mortgage-backed securities) packaged from these loans. It is difficult to see what a fiscal stimulus does to address the issue of solvency, for homeowners mired in negative equity or banks up to their necks in toxic assets. It neither stops house prices falling nor slows the process of foreclosure, which in turn crystallises losses. Until these issues are addressed, concerns over toxic as-sets and the solvency of the banking system will remain.
Investor behaviour is likely to remain volatile until there is more clarity over how the solvency issue is resolved and what lies in store for the real economy. When the US emerged from recession in 2002 the investment regime oscillated between long periods of risk aversion (safety first or riot point) and short-lived bouts of optimism. A similar pattern may emerge during 2009. Investor sentiment and asset prices look set for a period of volatility.
There are some scraps of comfort. Investors are selling government bonds and a modest rally in investment grade credit is the first hint that credit market conditions are improving. Stronger flows into emerging markets also suggest investors are beginning to look beyond short-term earnings risk to long-term growth prospect. Currently, to quote Much Ado once again, “the savage bull doth bear the yoke”. A return of confidence signaled by improving flows into risky assets could yet see that yoke thrown off.
Michael Metcalfe is global head of macro strategy, State Street Global Markets