It's Halloween: Financial Markets Are Jumpy.

More Trick Than Treat: Financial Markets Are Jumpy. With Good Reason... [¹]
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By The Economist (print edition) | 28 October 2007

Halloween arrived early for investors this year. Gone is the euphoria of late September and early October, when stockmarkets surged to new records, shrugging off the credit crunch and the spectre of a slowing American economy. Today's mood is jittery, with investors easily spooked by credit-market phantoms and the shadows of weak corporate profits. October 19th, the 20th anniversary of the 1987 crash, was a particularly grim day, with the Dow Jones Industrial Average falling almost 370 points. This week markets shuddered again as Merrill Lynch, an investment bank, reported its first loss in six years thanks to a large write-down on assets related to low-quality subprime mortgages in America.

In fact, the surprise is less the markets' nervousness now than their earlier confidence. That optimism was based on two shaky-looking assumptions: first, that economic damage from the summer's turmoil was either limited or would be mitigated by further interest-rate cuts from the Fed; and, second, that weakness in America's economy would, in any case, be countered by strength in the rest of the world.

Ghost-Busters

The credit markets, particularly the most dysfunctional asset-backed parts of them, are still something of a battlefield (see article). The corpses from the summer's turmoil— the "conduits" and "structured investment vehicles" (SIVs) which gathered up mortgage-related assets— have yet to be disposed of. That grim process is beginning, and with it the discovery of what subprime-related assets are actually worth. But dismembering SIVs will take time. And, in a cruel irony, American policymakers' ham-handed efforts to ease the pain, by giving an official stamp of approval to the idea of a super-SIV, have only added to investors' worries. If America's Treasury is involved, the logic goes, the SIV mess must be worse than it looks. Not surprisingly, investors feel risk-averse again. The spread between high-yield bonds and safe Treasury bonds, for instance, is now close to its peak in early September.

Even as investors are reminded that the credit crunch is not yet history, the news on America's economy is mixed. Thanks largely to booming exports, growth in the third quarter will turn out to have been quite robust. At the same time, the news from the housing market gets ever gloomier. Even though fewer houses are being built, the glut of unsold homes is growing. Tighter credit conditions are sapping already feeble demand. Existing home sales fell 8% in September, according to new figures. With the housing bust accelerating, the jobless rate inching up and oil prices close to record levels, the outlook for consumer spending is gloomy. And the gloom cannot be magicked away by America's central bankers, as euphoric investors seemed to think back in September. The next meeting of the Federal Reserve's rate-setting committee falls on Halloween, and judging by the price of Fed futures, financial markets expect a treat. As of October 24th, a cut in the federal funds rate was regarded as a certainty. But even if the markets are proved right and the central bankers do bring down the rate by another notch, the immediate economic impact will be modest. The effect of lower interest rates takes many months to work through an economy— especially when the housing market is in such a slump. And the risk of inflation could anyway stop the Fed from making aggressive interest-rate cuts.

Much depends on what happens outside America. For the past year or so, slower growth in America has been more than offset by strength elsewhere. Since America's biggest firms make around half their profits abroad, this strength has helped underpin share prices. But Japan and the euro zone— the most important players, measured at market exchange rates— are looking wobblier. The IMF, which just chopped its growth forecast for the American economy next year by nine-tenths of a percentage point to 1.9%, has also downgraded its figure for Japan (by three-tenths of a point) and the euro zone (by two-fifths of a point). Optimists put their faith in the booming emerging markets— China, India and the like. China, in particular, could counter American weakness by shifting more towards domestic consumption. But that outcome is not certain. Which is another reason why the markets' jitters will last long after the pumpkins have gone.

  M O R E. . .

Normxxx    
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