Late in the Cycle

Global markets for risky assets were excessively volatile during past quarter. What caused this, and does this tell anything about markets going forward?

The market turbulence began with the credit sector known as sub-prime mortgages in the United States. Sub-prime mortgages are simply mortgage loans made on excessively attractive terms to borrowers, who may not be able to afford the monthly payments over the long term. The risk is that many of these loans will not be fully repaid. Thousands of such loans are packaged into pools known as asset backed securities. These securities are, in turn, repackaged and sold in tranches to fixed income investors. The cash flows from thousands of mortgages are lumped together and provide the yield, which is purchased by banks, bond fund managers and hedge fund managers.

Due to excess demand from yield hungry investors, the banks created more and more of these asset- backed securities by lending mortgage money on increasingly lenient terms. Sub-prime borrowers were enticed to buy homes that they really could not afford. They were enticed by creative mortgages known as 2 and 28s. In this structure, borrowers are offered a subsidised interest rate for the first two years, which allows them to qualify for the loan. In year three, however, the monthly payment jumps to a much higher level, which the borrower cannot afford. If he is not able to sell the house or refinance with another innovative mortgage structure from another lender, he will fall behind on his payments and the loan will go into delinquency or default.

There is about one trillion dollars of sub-prime debt in the US and it is estimated that between 10% and 20% of that will ultimately be impacted. The sharp declines in the prices of sub-prime mortgage backed securities acted as a catalyst for credit spread widening in other credit sectors. The result has been that the spreads on investment grade bonds have widened by 80 basis points over the past several weeks and the spreads of high yield (or junk) bonds have widened by 175 basis points. However, prior to this episode, credit spreads had been too tight; they were not correctly reflecting the risks inherent in the underlying corporate credits. All that has happened is that risk has been re-priced to more normal levels. The sub-prime sector was the catalyst for this re-pricing of risk, but not the cause. The prices of risky assets had been too high and, at some point, were going to fall anyway.

Volatility in credit markets has spilled over into equity markets. Many equity market indices hit their highest prices for the year in mid-July, then fell sharply into mid-August. Regardless of the fundamentals in individual economies, almost all stock markets around the world moved together. Equity market pricing also is a barometer for risk appetite. When universal appetite for risk and risky assets diminishes, equity markets fall and credit spreads widen. As we move later in the economic cycle, it is inevitable that the markets will begin to forecast slower economies, reduced corporate profit growth and higher levels of defaults. The recent volatility in the price of risky assets is symptomatic of the late stages of the business cycle. Some equity markets may recover and make new highs; others will not. It is unlikely that credit markets will recover the very tight spread levels of a few months ago.

In the market for risky assets, we are either in the late stages of a bull market or the early stages of a bear market. In terms of asset allocation, the conclusion is the same - sell into strength! Investors who have capitalised upon the fantastic performance in equity markets and credit spread products over the past four years, should consider taking some risk off the table. As the prices of risky assets go higher the risk increases, and potential reward diminishes. It is not possible to predict price movements in the short term. Therefore, the most prudent course of action is to lock in some profits or set price targets to accomplish this. A programme of selling risky assets at progressively higher levels and switching into more defensive investments is the right one at this stage of the economic cycle. 

By Larry Jones, Chief Investment Officer, Nedgroup Investment Advisors (UK) Limited