We are told capital markets are forward-looking and rational. Why then are markets being hammered without there being a particular economic catalyst?
Sure, there have been some defaults in the U.S. subprime mortgage market. But that train wreck should have been recognized when the vehicle left the station. The U.S. housing market has been in retreat since the beginning of 2006 and the growth and deterioration in the quality of the subprime market has been well documented. Yet equity markets surged. Risk got virtually priced out of all markets, including corporate and emerging-country debt. It would seem that markets aren't that forward-looking and rational - something that is especially true where there is a shortage of both liquidity and transparency.
In this historical context, recent market events can be seen as a jarring correction for previous risk mispricing. This is not the first time markets have reacted in such a sudden fashion. But there is a particular twist now. Instruments have been created to divvy up risky assets and spread the holdings around the world. This can be a positive from the perspective of risk diversification. But the process lacks transparency. Investors, and even rating agencies, don't, for example, have a clear view of who holds U.S. subprime mortgages. Hence a lot of companies and countries with little exposure have seen their stock prices sideswiped.
We are also experiencing a fairly typical flight of capital to the key reserve currencies, such as the U.S. dollar and the yen. In the current circumstances this typical reaction to global uncertainty seems odd, given the U.S. housing market is the catalyst for much of the capital market woes. As the market correction spreads to commodities, we are seeing particular downward pressure on the currencies of resource-rich countries such as Canada, Australia and New Zealand.
A good part of the recent repricing of risk has been warranted. At the end of 2005, TD Economics predicted U.S. and Canadian equity markets would rise in the range of 6 to 8 per cent in each of 2006 and 2007. Despite recent carnage, the S&P 500 and the TSX are up respectively 11.4 and 12.8 per cent since the end of 2005. Credit spreads for riskier debt are more reasonable. Still, the speed of adjustment and the collateral damage to parties not particularly exposed to debt are unsettling.
The question then is, where do markets go from here? Do they recover from this new, lower base with valuations that more appropriately reflect risk? Or does a self-perpetuating downward spiral become entrenched?
The bad news from the U.S. housing and subprime mortgage market is far from over. The U.S. new housing market has likely bottomed out, but there is still a dramatic inventory overhang of resale homes and that will put further downward pressure on housing prices. In turn, that could bring more mortgage defaults and lower households' perception of their wealth and hence spending power.
Further, a lot of the recent U.S. mortgages have triggers that raise the interest rate on payments later this year or early 2008. This pending bad economic news could be an argument that the market adjustments are not yet complete. But these factors are well known and should have been reflected in the recent actions of markets.
The good news is that the world economy is sound. Growth is running around 5 per cent per year, which is more than a percentage point above the long-run average. Even with some spillover from the U.S. housing market to other parts of the U.S. economy, growth there might only soften to around 2 per cent. Previous episodes of credit crunches, such as in 1987, 1998 and 2001, had relatively happy endings and the underlying economic conditions were not nearly as favourable as now.
In each case, equity markets recovered after one quarter and were in positive territory after two. Central bank responses were a key factor in calming markets in those previous episodes. And central banks are once again playing a major role. The official interest rates set by central banks are roughly appropriate for the economic state of the world. But the actual market rates were drifting higher. Central banks have been bridging this disconnect by injecting massive amounts of liquidity. If needed - and it is not yet clear that this step is warranted - they could go further and, as in previous credit crunches, cut interest rates.
It should be noted, however, that driving rates down so low, and keeping them there so long, was the root of the market bubbles that are now being burst.
A dry economic assessment of the situation suggests previous patterns should be repeated and - even without any significant interest rate relief - order should be restored in markets shortly. This episode could be seen as a jarring way of restoring more reasonable, general risk premiums. As information becomes more available on who holds risky assets and what, if anything backs them, we will see further relative market price adjustments with the exposed companies and countries being hit further, while the clean parties see their asset valuations restored. Astute investors will recognize this as a buying opportunity.
But not everyone is as dry as an economist. It would be foolish to completely rule out a scenario where markets continue to flounder for some time. This could be driven by emotion or it could arise from revelations that some large institutions have greater exposures to risk than expected.
Economists do, after all, have two hands.
Don Drummond is a former federal associate deputy minister of finance.