Is the tidal wave of cheap money about to break?

published 2 August 2007

Any investor who can read a newspaper will by now have heard of CDOs and subprime mortgages. Some might even have a rough idea of what they are. But for anyone who's still confused by the murky world of credit derivatives, and how they are linked to mortgages and the broader economy, we can sum them up in one simple phrase: they're the canaries in the coal mine. And their plunging values are warning us that the cheap money boom is giving way to a credit crunch.

Asset prices across the world and all markets have been lifted on a wave of money, unleashed largely in the wake of the tech-stock crash and the September 11th terrorist attacks. Alan Greenspan, then Federal Reserve chairman, cut US interest rates sharply and kept them there, making it extremely cheap to borrow money, and lulling the entire world into a false sense of security. Meanwhile, cheap goods and labour from Asia and China and India in particular helped to keep a lid on inflation figures, which enabled central banks to justify keeping interest rates low, even as oil prices soared and property prices took off. This apparently stable, brave new globalised world of low interest rates and low inflation meant investors felt happy to borrow more and more money to take on ever more risk.

Arguably, one of the riskiest places to which all this money flowed was the US housing market. Some bright spark figured out that you could lend money to people with poor credit records and charge them higher interest rates. As long as house prices kept rising, the chances of them defaulting were relatively low they could always remortgage. Another bright spark realised that you could then parcel all these mortgages up into bonds and sell them to yield-hungry investors.

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If you were careful about how you sliced it, the top bits of these bonds could even get the top credit rating, because although they were the same subprime rubbish that was in the bottom sections, the lower tranches would take the hit first if anyone defaulted. When they were offered investment grade bonds paying the higher yields you'd expect from sub-investment grade debt, investors from hedge funds to pension funds piled in, not quite believing their luck. As demand rose, more subprime lenders sprung up, competing with each other for business, until it reached a point where they were lending money to almost anyone with a pulse.

As lending standards were tumbling, interest rates were creeping higher, and builders kept building more houses. As supply outstripped demand, house prices began to fall. Suddenly, when payments rose from the initial low teaser' rates, all those subprime borrowers could no longer remortgage against the rising value of their homes. And so more people than expected started to default on their mortgages. That meant that those mortgage-backed bonds, and all the derivatives spawned from them, weren't worth as much as everyone had thought. Investment bank Bear Stearns produced the first casualties. Two of its hedge funds that had specialised in mortgage-backed debt have blown up and revealed that they had practically no value left in them.

Since then, credit-ratings agencies have downgraded several such bonds and it seems likely that things will only get worse. Another $500bn of risky home loans sold with low teaser' rates are set to jump to much higher levels in the coming months as adjustable-rate loans taken out in 2005 and 2006 are reset. "It's like an onion; as you peel back another layer it just smells worse," said William Strazzullo at Bellcurve Trading to the FT. Christopher Flanagan at JP Morgan Stanley reckons almost half of these borrowers will be unable to arrange new loans to cut their payments as lenders have belatedly tightened up on their credit criteria. Even Federal Reserve chief Ben Bernanke is now admitting that the losses could be in the region of $100bn. Now in the context of global financial markets, that's big, but it's not world-shattering. Unfortunately, the problems aren't restricted to subprime.

Now credit spreads on high-yield corporate debt have widened sharply, rising from 6.9% to 8.2% in just one month. In other words, investors are now expecting a much higher return for investing in risky assets and that makes it more expensive for firms to raise money, or to fund buy-outs. This could be a problem for investment banks. The most high-profile potential casualty of the squeeze is private-equity group KKR's takeover of Alliance Boots. The banking consortium behind the deal has yet to find buyers for the £9bn of debt needed. But that's just the tip of the iceberg. Banks are already sitting on $100bn of debt from previous buy-outs that they haven't yet been able to sell onto the markets. And a further $270bn will hit the market later this year, according to Ambrose Evans-Pritchard in The Daily Telegraph. If the banks cannot offload this debt, it could leave them with "far more risk on their books than they bargained for, and could ultimately force them to pull back sharply on lending".

Already, 21 firms in the US have had to cancel bond sales "because nobody wants to buy them", says Bloomberg. Combine this with forced selling of assets backed by subprime mortgages, and you have a real problem brewing. TJ Marta, a strategist at RBC Capital Markets, says that some leveraged hedge funds could lose all their money, just like the two run by Bear Stearns, and if credit downgrades force mainstream investors to sell out of mortgage-backed assets at a loss, then "a vicious downward spiral could result, leading to the liquidation of other assets and positions, including the forex carry trade". This could have a nasty impact on assets with no apparent connection to US housing. As Bill Gross at Pimco puts it, "What has the Brazilian Real to do with US subprimes? Nothing except many of the same bets are held in hedge funds that by prudence or necessity will reduce their risk budgets to stay afloat."

The reason central banks won't cut interest rates immediately is that inflation won't let them. One of the main things that has kept inflation down in recent years is that China has been exporting deflation goods keep getting cheaper, while labour costs have been kept down by the influx of new workers into the global economy. But now China has begun exporting inflation. Prices of US imports from China rose by 0.3% last month, "the first sign I've seen that this disinflation pressure from China's cheap goods may be fading", said Greenspan. China's vast appetite for raw materials has continued to push the price of oil, metals and food higher, which in turn raises costs for consumers and firms, putting upwards pressure on wages and shop prices.

Even if central banks do cut rates and with the dollar in its weak state, that would be a risky step for the Federal Reserve the experience of Japan in the 1990s shows that slashing interest rates once consumer and corporate sentiment has turned from greed to fear is ineffectual. As Merrill Lynch puts it, "it seems the era of cheap money is over". So which assets will survive the credit crunch and which are going to run into trouble?

The first obvious casualty of the subprime collapse has been the dollar. It is now at a 26-year low against the pound, as investors worry that US interest rates may need to fall to offset an economic slump. But sterling can't stay this strong forever particularly not if the financial services industry is hammered by the credit crunch. The yen is likely to benefit, rebounding from current lows as investors bail out of their carry trades.

But the most obvious play on the fall of the dollar is gold. As Ambrose Evans-Pritchard points out on his Daily Telegraph blog, there is no realistic alternative world reserve currency to the dollar. The eurozone is heading for trouble as those countries that are being hurt by rising interest rates and the strong dollar, led by France, call for more control over the European Central Bank (ECB). Evans-Pritchard reckons the ECB will be forced to bend to their concerns "if it doesn't, the EU itself will blow up". Once it becomes clear that "neither of the two reserve currency pillars (the euro and the dollar) is on a sound foundation" and each is competing with the other to devalue, he reckons "gold will fly It might well go beyond $2,000". That's a heady prediction, but even if we don't end up returning to a situation where gold takes on even a partial role as a currency, in any market turmoil it should do well, due to its safe-haven' status.

Mining shares are in a bubble, says Robert Cole in The Times. We believe that many things are indeed at bubble valuations, but we can't agree with him on this one. The main concern for many commentators is that if the US economy goes into a housing-driven slump, commodity prices will collapse as it drags the rest of the global economy with it. We're not so sure. The reality is that, regardless of what happens with the US economy, China needs to continue with urbanisation and industrialisation. Goldman Sachs reports this year that the world will finally move to a point where urban populations overtake rural ones. The Chinese people (and the rest of emerging Asia) aren't going to stop wanting cars, air conditioning and indoor toilets just because Americans can no longer afford to buy their goods. In the interests of political survival, China's leaders have to make sure its economy remains on track if that means spending some of its hefty reserves pile, then so be it. We may well see a short-term knock-on impact on commodity prices, but in the context of Chinese development, it'll be a blip the supercycle will remain intact.

Things are even more bullish for oil. A recent report from the International Energy Agency predicted that the world would face a supply crunch within five years, stating that "slower than expected GDP growth may provide a breathing space, but it is abundantly clear that if the path of demand does not change on its own, it may well be driven to change by higher prices". Jeffrey Currie of Goldman Sachs reckons $95 a barrel is "quite likely" by the end of this year.

Of all asset classes, property (certainly in the UK) is probably the one on which we're most bearish. Yields on commercial property are below the yields available on risk-free gilts, making it look poor value, while rising interest rates mean that a growing number of buy-to-let investors are actually subsidising their tenants' rents. With UK interest rates still firmly on the upward path, the situation isn't going to get any better so sell your buy-to-lets, avoid commercial property and, if you're planning to buy a home, make sure you can afford to put down a decent deposit (at least 10%) and get a repayment mortgage, not interest only.

Until just this week, stockmarkets around the world had been blithely heading higher as if nothing was wrong with their cousins in the bond markets. But news that the US housing crisis is now spreading to homeowners with good credit records has hammered major indices, including the Dow Jones and the FTSE 100. And the slide may well continue. A recent Morgan Stanley report found that in the past 20 years, credit spreads began to widen an average six months before every stockmarket correction of 10% or more. The current widening in spreads began in February so that would point to a correction around about now. Morgan Stanley's model suggests a 14% fall in the Dow, which would take it back to around 12,000.

Meanwhile, in a piece entitled A Who's Who of Awful Times to Invest, John Hussman of Hussman Funds looks at conditions prevailing before previous stockmarket corrections back to 1961. He points out that, in each case, four conditions were met, including rising Treasury and corporate bond yields, and the S&P 500 trading at, or near, a four-year high. All four conditions were met again this month. "Every historical instance similar to the present has been a disaster," says Hussman.

It shouldn't come as a surprise that equities are vulnerable when liquidity dries up. As the cheap money vanishes, people have to focus more on economic fundamentals, rather than on what clever financial engineering could do for a company. Speculation about private-equity bids has driven up many of the mid-cap stocks, and these have already started to fall amid rising interest rates and concerns the private-equity boom has peaked. Share buybacks funded by debt are also threatened travel group Expedia has just slashed a share buyback plan by 80% due to lack of demand for the debt it would have used to fund the purchase.

What does this mean for your portfolio? One sector we've mentioned several times recently is the mega-cap stocks. These remain inexpensive, because they have always been seen as too big for private equity to buy. As mentioned above, we like oil majors Shell (RDSB) and BP (BP), trading on forward p/es of 10.4 and 11.6 respectively, and the big diversified miners, BHP Billiton (BLT) and Rio Tinto (RIO), trading on 12.9 and 12.2 times. Big pharma, meanwhile, is a traditionally defensive sector that looks attractive too. AstraZeneca (AZN) is on a p/e of 13.5 and yields 3.2%; GlaxoSmithKline's (GSK) p/e is 13, and it yields 3.8%.

As for smaller stocks, you have to take these on a case-by-case basis. Our own shares expert Paul Hill has flagged up the difficulty of finding decent stocks at acceptable valuations as the private-equity boom has lifted all boats. That's not to say you can't still find good picks, but it's more important than ever to make sure they are not over-indebted. As for foreign markets, we still like several of the Asian and Latin American emerging markets in the long term. The growth of these economies isn't going to be permanently derailed by a US-centred credit crunch. But as overseas investors become more risk-averse, it's likely that some of the more speculative money will rush out of these regions, so it may be better to hold off investing for now if you haven't already done so.

Of all the overseas markets, we still think Japan is the best. The Japanese economy is slowly recovering after decades in the wilderness. But a better reason for investing is this: the yen carry trade (where speculators borrow cheaply in yen to invest in higher-yielding assets elsewhere) has been sustained by the lack of volatility that has accompanied low interest rates and inflation, driving the yen to record low levels. But as investors become more fearful, volatility rises, making the carry trade riskier if exchange rates turn against you, you can rapidly lose any gains you've made, and end up owing more than you borrowed. As James Ferguson pointed out a few issues ago, the yen jumped against the dollar by nearly 50% in a matter of weeks during the 1998 LTCM meltdown. So the credit crunch could be very good for anyone invested in Japanese equities. Axa Framlington Japan (tel: 020-7374 4100) is among the top funds in the sector.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.