Gavyn Davies: Over-leveraged credit markets an accident waiting to happen

Markets were in free fall last week, with some equity indices (including the FTSE 100) eliminating all of their previous gains for the year.

Investors who have been holding sensible diversified portfolios did much better than those in UK equities, because international stockmarkets outperformed the FTSE, and other asset classes (like bonds and commodities) rose in value as equities collapsed. As the graph shows, balanced portfolios of global assets are probably still up by around 4 per cent this year. But if this sudden equity collapse turns into a prolonged bear market, there will be few places for anyone to hide.

A correction in risky assets has been long predicted by market pessimists, and indeed long-desired by many central bankers, who have been arguing that the risk appetite of investors has become excessive and dangerous.

Observing the behaviour of many hedge funds in the mortgage markets, it is easy to see their point. But remember that in the 1990s Alan Greenspan warned of "irrational exuberance" almost four years before the bull market finally ended. Investors who paid attention to him would have missed the second greatest bull market of the 20th Century, a mistake from which there is no swift recovery. So investment managers are forced to address the most difficult question of all - is this "the big one"?

The immediate genesis of the recent sharp correction in markets is straightforward. A bubble developed in the American housing market in 2003-05, and this has now burst with a vengeance. Although this has only reduced growth in US GDP by about 1 per cent per annum, it has caused severe problems in the US financial sector, parts of which had become severely exposed to the riskiest end of the housing loan market, known as sub-prime mortgages. Loans to sub-prime borrowers continued throughout 2006 and even 2007, well after the collapse in the housing market had become painfully visible, and packages of these loans were held by the investment banks, or sold to hedge funds, in new instruments called collateralised debt obligations (CDOs), which enabled investors to make leveraged bets on the health of the borrowers. When these bets proved misplaced, several hedge funds were wiped out, and the investment banks saw their share prices drop by 15 per cent or more.

So far, so messy. But none of this is enough, on its own, to spell the end of a global bull market. Estimates of the eventual losses which will be booked in the sub-prime market are generally around $100bn (£50bn), while the wealth of the American household sector exceeds $60,000bn. More troubling, perhaps, is the recent tendency for sub-prime woes to damage sentiment in other high-yield credit markets, where spreads relative to government bonds have risen from about 2.5 per cent to nearly 4.5 per cent. This will increase the cost of borrowing in much of the economy, and also make it more expensive for private equity firms to use leverage in equity buy-outs.

All this could damage the stockmarket and the economy, especially if the available quantum of credit becomes restricted, as well as becoming more expensive. Academic evidence suggests that a "credit crunch" of this type can do significant economic damage.

This will undoubtedly happen for a while. Now that the credit debacle has spread beyond the mortgage market to the corporate debt market more generally, the banks will inevitably become much more cautious. They are reported to be sitting on deals worth $200-300 billion which they have underwritten, but are now unable to pass on to syndicates.

Although the losses on these loans are likely to be only a few per cent of the banks' equity (at most), the loan markets will seize up until this debt can be shifted into the hands of final investors, who have currently taken fright.

This episode will not blow over in just a few days, and it could easily get much worse before it begins to stabilise. The credit markets have been excessively leveraged, with spreads on risky tranches of debt far too narrow, for a couple of years at least. They were an accident waiting to happen.

However, we have seen several episodes like this unwind in the past, without this causing either a recession or a prolonged equity bear market. Several examples come to mind: Continental Illinois (1984), Black Monday (1987), Mexico (1994), Asia, Russia and LTCM (1997). In each case, tightening by the Federal Reserve caused the weakest link in the economic chain to keel over, but the rest of the system proved to be fundamentally sound, and equities eventually rallied sharply.

I am inclined to believe that the same may happen this time. The equity bull market of 2003-07 has been based on four solid foundations, all of which still remain intact.

First, there is the performance of the world economy, which continues to grow at 5.2 per cent per annum, with core inflation remaining stable at 2 per cent or less. Although the US housing debacle is hitting the American consumer, there is plenty of evidence of strength in Europe and Asia to offset this. Only last week, the IMF revised down its US GDP forecast to 2.0 per cent in 2007, but simultaneously revised up their growth forecasts in Germany (2.6 per cent), Japan (2.6 per cent), China (11.2 per cent), India (9.0 per cent) and Russia (7.0 per cent).

Second, and consequent upon the buoyancy of the global economic expansion, the underlying strength of the corporate sector shows little sign of going into reverse, even in the US. Corporate earnings announced so far in the second quarter are growing at a 9 per cent rate, instead of the 5 per cent rate which was widely predicted at the start of the US earnings season. Yet again, pessimistic analysts have been confounded by the ability of the company sector to maintain healthy rates of profits growth.

Third, because of the rapid growth in profits, the valuation of equity markets has never risen much above average in the recent bull market. In the US, for example, the earnings yield on the equity market is currently around 6.1 per cent, compared to a yield on long-term government debt of only 4.8 per cent. It is very rare for equities to offer a yield in excess of government bonds, let alone a gap of 1.3 per cent in their favour. If any asset is expensive (apart from corporate debt, which was expensive but is now much less so) it is government bonds, not stockmarkets.

Fourth, because inflation is basically under good control, global central banks have still not shifted monetary policy into the abnormally tight territory which frequently spells doom for economies and stockmarkets. In the G7 economies, real short-term interest rates are around 2.5 per cent, compared to the 4 per cent level which has been needed to do damage in the past.

More importantly, China and other emerging economies contimue to pump hundreds of billions of dollars into the global markets each year in order to hold their currencies down against the dollar. While they continue to do this, the main engine of global excess liquidity, which has driven asset prices higher, seems to be broadly intact.

Watch the central banks, especially in the emerging world. When their behaviour, not just their language, turns hawkish, the party will be finally over. Until then, probably not.

Gavyn Davies is a founding partner of Fulcrum Asset Management and Prisma Capital Partners

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