The Financial Butterfly Effect

In July 2007, volatility returned to the markets with a vengeance for the first time since late February. Once again, the US housing market was the catalyst for the widespread declines. It may seem strange that one country's housing market woes can cause a worldwide stock market sell-off, but with the global economy linked in a myriad of ways, this financial butterfly effect is not surprising.

"This renewed focus on risk has had a greater impact on stocks than the housing market itself."

This week, we'll give our take on how a rumbling US housing market can reverberate around the world, and why we believe there is no reason for investors to panic just yet.

We say 'just yet' because we believe the housing market still has some pain to endure. The impact on consumer spending and therefore on US economic growth could be greater than markets are currently pricing in.

But before we discuss the potential for further weakness, let's look at the cause of the recent volatility.

For some time now, concerns have mounted about the state of the 'sub-prime' mortgage sector in the US. Sub-prime borrowers are those people with weak credit histories. Without a credit bubble assisting lax lending standards, many of these borrowers would not have been able to buy into an inflating property market during 2004 and 2005.

But buy they did and their loans were packaged and sold off to numerous buyers looking for higher yields. Hedge funds in particular invested heavily in the sector, looking to increase returns by adding leverage (debt) to the mix.

When US house prices stopped rising during 2006, and low introductory interest rates increased by several hundred basis points, many borrowers began to default on their loans. This in turn put pressure on the highly leveraged investors in the loans - mostly hedge funds.

After the collapse of the Bear Stearns hedge funds, countless officials reassured investors that the sub-prime issues were isolated events and were nothing to worry about. (take market forecasts from politicians or officials with a very large grain of salt.)

Soon after these calming words were uttered, Countrywide Financial, the largest mortgage lender in the US, warned that earnings would be weaker because a broad range of borrowers were getting behind in their loan repayments, not just sub-prime borrowers! Soon after, investors began to realise that perhaps risk had been priced too low for too long.

This renewed focus on risk has had a greater impact on stocks than the housing market itself. The increase in risk aversion has had a number of effects. The cost of 'risky' debt (anything other than government debt), has increased substantially over the last week, albeit from low levels.

Borrowing rates for companies and private equity consortiums have therefore increased, which has a big impact on the potential for debt funded takeovers.

This has resulted in a fall in the share price of many perceived takeover targets.

The higher cost of borrowing has another consequence for the market. We believe the stock market is highly geared from an investor's perspective.

Many individual investors, as well as hedge funds, have borrowed heavily to invest in the market. When sentiment turns, as it did last week, these highly leveraged players exacerbate the volatility by liquidating any asset to pay down their debt levels.

The increase in risk aversion had significant implications for Japan. The yen carry trade, which involves borrowing yen cheaply and investing the proceeds just about anywhere else other than Japan, unwound very quickly. This is partly the reason behind the steep falls in the Aussie dollar in recent days as short-term speculators took to repaying their yen-based loans.

To make matters worse for the Australian market, inflation is now flashing as a warning sign and the Reserve Bank is expected to raise interest rates again in the next few weeks. We do not think an interest rate rise is a foregone conclusion but as Members will know, we have been concerned about rising inflationary pressures in Australia for some time.

"To make matters worse for the Australian market, inflation is now flashing as a warning sign and the Reserve Bank is expected to raise interest rates again in the next few weeks."

All this has resulted in a big mid-week pullback in the Australian share market. Sparing very few stocks, investors took profits on the fundamentally sound resource sector and sold off banking and financial stocks on concerns that credit growth would begin to slow. Perceived takeover targets were also marked down

As an indication of the increase in risk aversion, Macquarie Bank stock fell from over $86 to less than $75 in a matter of days. Macquarie has been a major beneficiary of the loose credit conditions in recent years, and investors are now seeing tougher times ahead.

The global outlook will obviously have an impact on the Australian market in the months ahead, and while the outlook in Australia is for higher interest rates, in the US, official interest rates may go the other way. As we have written previously, we believe the US housing market will continue to weaken throughout the year, putting greater pressure on highly-geared home owners and investors in mortgage debt.

Just as consumers increased their spending when house prices were rising, they are also likely to cut back when their primary asset is falling in value. Considering consumer spending accounts for 70 percent of the US economy, a consumption slowdown would likely tip the US economy into recession.

The performance of the US consumer has implications for the global economy too. Excess consumption in the US is the reason behind the country's $60 billion monthly trade deficits and $800 billion current account deficit.

Paying these bills with US dollars creates a huge amount of global liquidity.The deflationary impact that would likely ensue from a slowing housing market and weaker consumer spending would allow the Fed to lower interest rates, probably toward the end of the year. Investors appear to have priced this scenario in to some extent. Government bonds have rallied in recent weeks (meaning yields have fallen) and the US dollar has been very weak.

Although Fed Chairman Ben Bernanke remains vigilant on the threat of inflation, he may be fighting an old battle. If the bond market were concerned about inflation, we would not be seeing 10-year government bond yields at 4.8 percent, well below the cash rate of 5.25 percent.

Getting back to the markets, we believe that the sharp falls experienced in recent days signal the beginning of a lengthy consolidation phase. However, we expect the upcoming reporting season to deliver reasonably solid earnings, and this good news could lead to a share market rally.

In particular, we expect the resource sector to do well, justifying the sharp re-rating the sector has experienced in recent months. Elsewhere, we are continuing to avoid banking-related stocks and other financials on the basis of unfavourable risk/reward characteristics.

We continue to recommend reducing risk by de-leveraging. That is, reduce margin loan exposure to comfortable levels. Investing should be rewarding emotionally as well as financially, and there is no joy in taking big bets on borrowed funds, when markets turn sour. Corrections serve to remind us that the market can cut both ways, and that our comfort levels are very important.