When Ben Bernanke, head of the US Federal Reserve, arrived at his Washington
office early last Monday morning, the mood could scarcely have been bleaker.
In the previous few days, Merrill Lynch, JP Morgan, Wells Fargo and
Citigroup had announced a further round of write-offs running into billions
of dollars - on top of those they had disclosed in the autumn.
Figures suggested that American industry was heading for a sharp downturn. In
Europe, surveys of companies were almost as downbeat. And perhaps most
importantly, Ambac, the world’s largest bond insurer - a company that
insures against the risk that debts turn sour – had seen its credit rating
slashed.
Stock markets across Asia and Europe had already plummeted on Monday. The FTSE
100 index was suffering its largest one-day points fall since it was created
in 1983 – probably aggravated, as later became clear, by Société Générale’s
efforts to unwind huge positions taken out by rogue trader Jerome Kerviel.
Bernanke, a 54-year-old former academic with less than two years in the chair
at the Fed since the departure of the veteran Alan Greenspan, faced his
toughest test. He knew American investors would sell shares as soon as they
could – Wall Street would follow the precipitate declines already seen on
stock markets to the east.
But at least Monday was a public holiday in America – Martin Luther King day.
Bernanke had until the following morning to decide how to tackle the crisis
in the financial system – and try to limit the impact on the economy.
Just after lunch Bernanke called a brief meeting of the Fed officials who look
at interest-rate policy. He and his colleagues agreed that drastic action
was needed. The Fed’s open-markets committee was not due to meet until
Tuesday this week, a further eight days away. But Bernanke convened a
meeting of the committee – by videolink because of the short notice – at
6pm.
Within 90 minutes, a decision had been reached: interest rates should be
slashed by 0.75 percentage points – the largest single cut for more than a
quarter of a century. All but one of the nine committee members taking part
agreed that the Fed should cut rates straightaway. The dramatic move was
announced the following morning, just as dawn was breaking in New York.
Within 72 hours, there were two further initiatives aimed at quelling
investors’ fears. On Wednesday, it emerged that the American government was
trying to broker a plan to shore up the bond insurers. The following day,
President George Bush and leaders of the House of Representatives agreed a
$150 billion package of tax cuts.
The effect on stock markets of the Fed’s interest-rate cut was certainly
helpful. It stopped Monday’s share-price falls in Asia and Europe gaining a
new momentum as markets opened in New York. But still the Fed’s initiative
was not enough to stop a small slide in share prices on Wall Street.
By contrast, Wednesday’s news of the bond-insurance rescue plan was
electrifying. That day, Wall Street’s S&P 500 index had fallen
more than 2%. But as reports of the rescue began to leak, it rocketed,
ending the day 3.1% up – an extraordinary turnround within a single trading
session.
Analysts at the Citi banking group calculated that equities were at their most
volatile for at least four decades. The FTSE 100 index, having suffered its
biggest-ever one-day points fall on Monday, clocked up a new record on
Thursday – this time, for the biggest-ever rise. By Friday evening, UK share
prices – whose headlong descent just days earlier had prompted shrieking
headlines about the danger of a collapse of the global financial system –
were within a whisker of their level seven days earlier. What had all the
fuss been about?
Certainly, the previous week’s poisonous cocktail of news – on bank
write-offs, the “monoline” bond insurers’ woes (see panel on opposite page)
and cuts in corporate investment plans – had created a deeply pessimistic
mood.
But on top of that, economists were edging towards the view that the US
economy could be heading not merely for a slow-down but into recession.
Last weekend, David Rosenberg, Merrill Lynch’s North America economist, issued
a research note that added to the expectation that US economic growth would
not merely slow in 2008; it would, he predicted, come close to grinding to a
halt. He halved his growth forecast from 1.6% to 0.8%.
Rosenberg’s analysis of prospects for America – still, despite the emergence
of new economic power-houses in the East, accounting for more than a quarter
of global output – was sharp and pessimistic.
Raw figures for American employment in December appeared to be – by a fraction
– positive. But, Rosenberg pointed out, the data take no account of the
self-employed. The number of people working for themselves has tumbled by
500,000 in the previous six months.
Furthermore, he said the fall in American house prices could have much further
to go: they could drop by as much as 30% over the coming two or three years.
Rosenberg said: “This sounds dire (and it is, effectively wiping out three
years of price appreciation) but would reverse only part of the
unprecedented 130% price surge from 2000 to 2006.”
And the American stock market could fare no better, he said. “If in fact the
economy is in recession or on the precipice thereof, then the historical
record shows that these setbacks in the real economy usher in an average 25%
decline in the S&P 500.”
Americans have $400 trillion tied up in their houses and the stock market. Any
big fall in the value of those investments would inevitably reduce their
willingness to spend.
In any case, said Rosenberg, American consumers are bound to draw in their
horns: they are up to their eyes in debt. He cited a telling statistic. In
1962, American household debts were equivalent to 64% of incomes. It took 39
years – to 2001 – for that ratio to reach 101%, an increase of 37%. Since
then, it has increased by a further 37% – in a mere six years.
Put simply, America’s spending and borrowing binge has to come to an end some
time and that time is probably now.
And even in London as the share prices tumbled on Monday morning, there were
plenty of people prepared to say the stock market had further to fall.
Morgan Stanley’s chief European strategist Teun Draaisma said: “We continue
to prefer cash over equities . . . we expect EPS [earnings per share] growth
to be negative in 2008.”
The bears, their instincts bolstered by both economists and strategists, were
in control. YES, things looked bad. But were they really as bad as the
market appeared to be suggesting at the beginning of last week? The question
was at least being raised – although few stock-market pundits were yet
prepared to say that shares had fallen so far that now was the time to buy.
One brave soul, Mike Lenhoff, chief strategist at Brewin Dolphin, was prepared
to stick his neck out. He said on Monday: “If interest rates are cut to the
extent we and others expect, the likelihood is that today’s share prices
will look like silly values in 12 months’ time, if not before.”
And others were beginning to do calculations that suggested the market was
indeed looking remarkably cheap.
One measure of share prices is their dividend yield and how it compares with
the yield on government bonds. At any one time, yields on equities are
usually lower than those on bonds: after all, companies try to increase
their payouts year by year; governments don’t. Hence investors are prepared
to accept a lower yield on equities today in the expectation that it will
rise in future years.
But at times when the stock market is in real trouble, share prices may fall
so far that the yield on equities is no lower than that on government bonds:
the gap closes.
The last time that equity and bond yields were identical was during the 2003
invasion of Iraq: the FTSE 100 briefly dipped below 3,300. With hind-sight,
it was a huge buy signal. By the end of that year, the FTSE 100 was back
above 4,000; in 2006, it broke through 6,000.
Using a slightly different methodology, Merrill Lynch’s European investment
strategist Karen Olney calculated that one would have to go back even
further to find a time when shares in London had fallen so far that the
equity/bond yield gap had closed completely.
She reckoned that the last time was way back in 1974 – before many of today’s
stock-market practitioners were even born. It was a time when inflation was
running at 20%, London was being regularly bombed by the IRA, Glenda Jackson
was appearing on the Morecambe and Wise Show and Barry White topped the
charts with You’re the First, the Last, My Everything.
It was a different era, but the lesson for January 2008 is telling: investors
who had the courage to buy shares at the market’s low point in December 1974
doubled their money in three months.
And after last Tuesday’s sharp cut in American interest rates, even Morgan
Stanley’s Draaisma – who, just 48 hours earlier had warned investors that
there might be worse to come – was prepared to advise clients to start
nibbling at equities. He said: “The market is oversold enough for us to be
wanting to buy a bit today.”
By the end of the week, Citi’s strategy team was also pointing out that across
Europe, share prices had fallen so low that investors appeared to be
budgeting for a 30%-35% fall in corporate earnings – about as pessimistic as
you could get.
Even now, after all the cogitating, analysis and drama of the past week, there
remains a lack of consensus about the direction that stock markets will
take. Merrill Lynch’s Olney admitted that the volatility of stock markets
has been breathtaking. She said: “The ferocity of it has to do in part with
the complexity of some of the derivatives that have been bought on the way
up.”
And even hedge funds – which are meant to be able to make money when the
market falls as well as when it rises – appear to have been clobbered.
One hedge-fund manager said: “In the past few weeks, most hedge funds have
been overwhelmingly long on the market. Worse, when they were hit by such
sudden dips, many kept buying, which has compounded the losses.”
A rival manager added: “There’s blood on the street. I’ve never seen anything
like it. Others are desperately trying to liquidate their positions to meet
margin calls and preserve capital. The selling is making the market worse.”
Worse? Well, for a couple of frantic days last week, the market appeared worse
than it had been for years.
Bernanke came to the rescue with his interest-rate cut last Tuesday. He and
his Federal Reserve colleagues are likely to orchestrate a further
interest-rate cut in two days.
Nobody thinks there won’t be further bank write-offs and shocks to the global
financial system.
But after a week from hell, some investors are allowing themselves to
entertain hopes that the very worst may be past.
MARKET TALK
The markets have gone a long way towards pricing in a doomsday scenario . .
. the European market is a buy once fear subsides. Karen Olney, equity
strategist at Merrill Lynch UK, Tuesday
That’s enough for now. We believe the 20% drop in Europe from the peak in
June 2007 is enough of a correction. Teun Draaisma, head of European
equity strategy at Morgan Stanley, Wednesday
Lots of people are going to get very rich over this situation. There are
all kinds of opportunities. Jack Welch, former chief executive of
General Electric, Wednesday
So far we have had about a $100 billion of writedowns, and that's not the
bottom.
John Thain, chief executive of Merrill Lynch, Friday
