A shock to the system: It isn't only the economy, stupid

Market.view

Mar 4th 2007
From Economist.com

WILL the past week’s market sell-off prove to have been a seven-day wonder? The investment community quickly split into two camps. One group, which made frequent appearances on CNBC, a financial news channel, argued that the fall in share prices was a freak event. It maintained (unconsciously echoing President Herbert Hoover after the 1929 crash) that the “fundamentals of the economy are sound”.

The more bearish seized on the crash as a sign of a coming apocalypse. A notable member of this camp was Andrew Smithers, of Smithers & Co, who said the fall “could be the start of the second leg of the major bear market which started at the end of March 2000.”

Whether or not Mr Smithers turns out to be right, investors need to be wary of relying too much on economic fundamentals as a guide to the market’s immediate outlook.

For a start, the market is supposed to be a forecasting mechanism, so it may be warning of economic problems ahead. There were few signs of economic problems in March 2000 when the dotcom bubble popped, but a mild recession duly followed.

Second―a point made by Bill Gross, a bond guru at Pimco, a fund management firm―these days it is often the financial markets that are driving the economy, rather than the other way round.

Think about the rise in profits as a percentage of GDP in America and elsewhere. That has enriched companies and their shareholders at the expense of workers. But if workers are being squeezed, why hasn’t consumer demand been hit? Because consumers still feel wealthy thanks to the rise in share and (until recently) house prices.

Furthermore, look at the extraordinary success of the financial sector. Profits have been rising relentlessly and bonuses have been exceptional. In the UK, the financial sector is a vital driver of the economy, which is why the current government would be mad to drive it away by, for example, capping bonuses or attacking private equity.

But the financial sector’s success is driven by 20 years of rising asset prices and falling interest rates. Remember how the Federal Reserve rushed to cut rates when the financial sector was hit in 1998 and 2001. Think, also, how the Japanese economy struggled through the 1990s, thanks to its ailing banking system.

So it is the mechanics of the financial system itself that will determine the prospects for the markets. Here there are dangers. Banks have been disintermediated. They can no longer rely on taking deposits from retail customers and lending the proceeds at higher rates to business.

The corporate sector borrows from pension funds, insurance companies and the like. The banks merely arrange the deals. This transaction activity, covering everything from stockmarket flotations to complex derivatives, is a vital source of income, as is the trading of those instruments when issued.

Any shock that dries up liquidity is a threat to the financial sector, and the markets. Reduced liquidity means less issuance. A reluctance to hold illiquid assets means lower prices, a blow to the trading arms of the banks.

Hedge funds also provide liquidity to the markets, because they trade much more often than traditional investors. Dresdner recently estimated hedge funds delivered 15-20% of investment banking revenues. Hedge funds are natural buyers of illiquid assets (where prices are most likely to be incorrectly set) and also sellers of volatility.

Those who sell volatility (the equivalent of writing insurance on financial markets) receive a steady stream of premium income that looks impressively smooth to investors. Liquid and less volatile markets look safer and appear to justify higher prices.

We thus create a virtuous circle in which investment banks and hedge fund together drive volatility down and liquidity and prices up. But at some stage, this process cannot be pushed any further.

The risk is what happens when the process unwinds. Prices fall, causing hedge fund and investment banks to retreat from the markets; this reduces liquidity, implying lower prices and so on.

Perhaps the shock of February 27 was insufficiently drastic to send the process into reverse. But that is the risk that investors should be most concerned about. In the next few weeks, they should be looking for signs of distress in some of the less liquid areas of the markets, such as high-yield bonds and credit derivatives.