Here we go again – the latest sub-prime driven correction

SHARES have seen another downswing led by sub-prime related woes and further falls are possible.

Introduction

It seems that we have only just recovered from the big correction in shares into mid-August and yet share markets have been hit by another bout of weakness. From their recent highs to their lows in the last few days US shares have fallen 8.5%, UK shares 7%, European shares 5.5% and Australian shares 6%. Asian shares have fallen around 9.5% (after a 39% gain since mid-August) and Japanese shares have had a 14% fall with the stronger Yen clearly taking its toll. This is the third major correction this year led by the US sub-prime mortgage crisis (ie rising defaults amongst low quality borrowers). The first was in February, then August and now. This is starting to feel like Groundhog Day!

What’s the problem now?

The latest share pullback reflects a range of factors:

·       Losses on residential mortgage backed securities – notably sub-prime mortgages – and related investments are leading to big asset write downs, by US investment banks in particular. So far, write offs by major organisations amount to about $US50bn. There is talk of much more to go and the rumour mill has been in overdrive. Rough estimates based on potential default and loss rates for US mortgages suggest big losses. If defaults reach 20% on sub-prime mortgages, 7% on Alt-A mortgages (which are basically low doc loans) and 1% on prime which all incur ultimate losses of 35% then total losses could be as high as $US150bn.

Potential direct US mortgage losses

Source: AMP Capital Investors

Financial markets have already moved to price this in and in many cases appear to be assuming an even worse outcome (eg some US residential mortgage backed securities – ie pools of mortgages bundled into tradable securities – are now priced such that an investor would break even if there was a massive 45% default rate and a 90% loss rate on the underlying mortgages). What we are now seeing is financial organisations move to reflect this in the value of their assets, hence the big write offs. But as we have seen with market pricing the likelihood is that write offs will end up going further than the actual likely recovery rate for the investments.

·       This is adding to fears of a serious credit crunch as asset write-downs will slow the ability of banks to make loans which will in turn make the US housing downturn worse. While conditions in credit markets have improved since August they remain a long way from normal. Funding for asset backed commercial paper, particularly mortgage-backed securities, remains very weak. Reflecting investor risk aversion, the yield gap between the 3 month $US lending rate between banks and 3 month US Treasury Bill yields remains unusually wide. In fact since late October this gap has spiked higher again as credit worries have re-intensified.

·       Worries about the US economy are intensifying as the US housing downturn is showing no signs of a bottom and the risk of a flow-on to consumer spending rises.

·       At the same time the surge in the oil price since August adds to pressure on the already vulnerable US consumer and global growth generally.

·       This is all occurring when the Fed is seen as preferring to leave interest rates on hold at its next meeting. Investors fear that the Fed will be less willing or (thanks to the inflation threat from higher oil prices and the lower $US) less able to rush in with further rate cuts.

·       In addition, the recent acceleration in the US dollar’s decline has also weighed on share markets on fears that it has gone from being benign to becoming a crisis as a collapsing $US may lead to a rush out of US assets and at the same time put pressure on economic growth in other countries, eg Europe and Japan.

Risk has gone up, further weakness is possible

To be sure, uncertainty about the outlook has gone up:

·       The risk of a US recession is high and rising and this is adding to downwards pressure on US profit expectations. The credit crunch may have faded but it certainly hasn’t gone away. There is more bad news to come in the US housing market with roughly numerous sub-prime borrowers due to reset to higher mortgage rates. The combination of falling house prices and higher energy prices is sure to have some dampening impact on consumer spending going forward. Finally, surprisingly strong US economic growth over the last two quarters by robbing from future growth has actually increased the chance of a couple of very weak quarters just as payback. We see US growth averaging around 1-2% over the next year, but there is certainly a high risk of a negative quarter.

·       The uncertainty about the likely losses flowing from the sub-prime crisis provides an ideal environment for panic driven selling of investments.

·       The Fed has arguably mis-judged the risks facing the US economy and will be forced to cut rates further. But until investors become more confident that it will continue easing then share markets may remain weak.

These considerations suggest that, notwithstanding a decent bounce in the last day or so, shares may still see more weakness in the next few weeks.

Another correction, not a bear market

However, while the risks have certainly increased and there is reason to be cautious in the very short term, our view remains that the trend in shares will remain up.

·       Firstly, while a $US150bn or so mortgage loss sounds high it is way less than the losses incurred following the savings and loan crisis of the early 1990s and is not disastrous relative to the size of the US economy.

·       Secondly, share market valuations are still reasonable and have become more so as share prices have fallen and bond yields are lower. Thanks to very strong earnings growth over the last few years price to earnings multiples are well below previous extremes.

As a result, the ratio of share prices to forward earnings for Australian shares today is around 15.5 times which is only marginally above its 10 year average (of 15.3 times) and well below its 1999 high.

·       Secondly, while profit growth will slow over the next year the sort of slump in profits that is associated with a bear market is unlikely. Global growth is likely to slow but should still remain reasonable. The US will flirt with recession as the housing slump flows through to consumer spending but should manage to avoid it, helped by a strong corporate sector, slowing imports and rising exports and further action by the Fed. More broadly the global economy as a whole is in reasonable shape. Developing countries are likely to remain strong. The latter now account for 30% of world GDP and are growing at 6% on average. Similarly the Australian economy looks like continuing to motor along despite more interest rate hikes and a very strong $A. The boost to national income from the resources boom is continuing and tax cuts will help consumer spending.

And while cost pressures have increased, companies seem to have been adept at offsetting them with efficiency gains.

The bottom line is that while global and Australian profit growth will slow significantly, profit levels are unlikely to collapse in a way that significantly undermines share market valuations.

·       Thirdly, global monetary policy hasn’t been tightened aggressively enough to threaten shares and in fact is now starting to ease, led by the US. Lower US interest rates should enable price to earnings multiples to rise (as lower interest rates reduce the whole global yield structure) thereby helping to offset the dampening impact on share returns from lower earnings growth.

·       Finally, there has not been the sort of generalised investor exuberance that normally precedes bear markets as in the late 1990s tech bubble.

·       It is also worth noting that after a sharp rebound from mid-August to their recent highs (Australian shares rose by nearly 25%) shares were due for a correction, which is what we have been seeing.

Overall this suggests the trend in share markets is likely to remain up. It is also worth observing that the period from now into January is normally strong for shares as tax loss selling in the US abates, investors look forward to the New Year and many invest their bonuses. So while we may still see further weakness over the next few weeks shares are likely to rise solidly into year end (probably helped by another Fed rate cut next month).

However, the extreme volatility seen this year makes it clear that the nature of the share bull market has changed. Profit growth is now slowing and shares are now more dependent on liquidity from lower US interest rates and fund inflows. This means the ride for investors will remain volatile. This stage of the cyclical bull market is also likely to see a focus on a narrower range of investment themes which will result in an increasingly narrow participation in the share market’s advance. This is already evident but is likely to become more so with emerging/Asian markets and related themes such as resources likely to be key beneficiaries. As such Asian and Australian shares are likely to remain relative out performers helped by stronger economies and earnings outlooks.

Concluding comments

While further downside in shares is possible in the very short term and there is good reason to be cautious, the broad trend is likely to remain up. However, the ride for investors is likely to remain volatile.

By Dr Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors.*

Australian Property Journal