Markets in turmoil on fears of credit crunch

The past week was a tumultuous one for global markets. Stocks and most other risky assets around the world fell sharply as investors rushed into government bonds amid increased concerns over the availability of cheap credit in the wake of problems in the mortgage market in the United States. However, investors should probably remember that a similar bout of risk aversion last year had proved relatively short-lived.

Last week provided additional evidence that the problems in the US mortgage market are far from over. US home builders releasing financial results last week reported large losses and write-downs in the face of declining land prices. And Countrywide Financial, the second-largest US retail mortgage lender, confirmed fears that problems in the industry extended beyond subprime mortgages by reporting that delinquencies on prime home-equity loans to borrowers with high credit scores jumped to 4.6 percent in June from 1.8 percent a year earlier.

The problems in the US mortgage market is having wide-spread impact. In a move reminiscent of the problems faced by two Bear Stearns hedge funds last month, Australian hedge fund Absolute Capital Group Ltd announced last week that it had suspended withdrawals from two funds after forecasting losses on US subprime mortgages.

In the light of these developments, investors are becoming more risk-averse and are less willing to part with their cash. Last week brought news that bankers for Chrysler and Alliance Boots Plc had to take on loans to the companies after having difficulty in selling their debt.

The rising risk aversion resulted in a worldwide sell-off in stocks last week. The Standard & Poor's 500 fell 4.9 percent to 1458.95 last week, its worst weekly loss since September 2002. Elsewhere, the Dow Jones Stoxx 600 Index fell 5.1 while the Morgan Stanley Capital International Asia-Pacific Index lost 3.9 percent to 154.50.

Investors fled to safer investments, as a result of which government bonds rose and yields fell. The yield on the benchmark 10-year US Treasury note fell 19 basis points to 4.76 percent last week, the biggest fall in ten months. Elsewhere, the yield on the German 10-year bund fell 11.6 basis points to 4.32 percent while the yield on the 10-year Japanese government bond fell 10.5 basis points to 1.78 percent.

The rising risk aversion also meant some unwinding of the yen carry trade. For example, the New Zealand dollar fell nearly five per cent against the yen last week. That came despite the Reserve Bank of New Zealand raising its benchmark interest rate by a further 25 basis points to 8.25 per cent on Thursday.

The real economy took a back seat in investors' minds last week. Largely ignored was the International Monetary Fund raising its projections for global growth in both 2007 and 2008 to 5.2 percent from 4.9 percent. Also largely ignored was the 3.4 percent growth rate the US economy reportedly achieved in the second quarter.

On the other hand, with the focus on the credit market, the continuing deterioration in the US housing market was certainly not ignored. Last week's housing data showed that existing-home sales in the US fell 3.8 percent in June while new-home sales fell 6.6 percent. This followed a report from the National Association of Home Builders the previous week that its Housing Market Index fell four points to 24 in July, the lowest level since January 1991.

Amid all the selling, though, it is probably useful to remember that we have been here before. I am talking not so much of the jitters in February this year but the flight to safety back in May-June 2006. Notice from the accompanying chart how close interest rates in the US are today with those at that time.


However, mid-2006 proved to be a peak for interest rates and a bottom for stock markets. History could repeat itself and stock markets could stabilise or even recover soon. After all, global economic growth remains good and stock market valuations remain reasonable. The S&P 500, for example, now trades at a price-earnings ratio of 17.5, or an earnings yield of 5.7 percent, almost a full percentage point higher than the 10-year Treasury yield. Further risk aversion would push the Treasury yield even lower, making stocks appear even more attractive by comparison.

Nevertheless, the heightened concern over the possibility of a generalised credit crunch resulting from the troubles in the US mortgage market is also well-grounded. Like other interest rates, mortgage rates in the US also saw a short-term peak in mid-2006 but despite the subsequent decline in rates -- a decline that has since been reversed -- we are still waiting for a bottom in the US housing market. As the weakness in the housing market drags on, especially as adjustable-rate mortgages reset at higher rates in coming months, mortgage delinquencies and defaults will continue to rise, leaving the overall credit market looking increasingly fragile.

So there is reason to think that stock markets and risky assets in general could stage a rebound before long but the downside risk is real and investors in these markets could be in for more anxious moments.