Reflationary efforts will gradually unfreeze the credit markets. Nevertheless, the need to unwind this decade’s credit excesses means that the economy will continue to face major headwinds to growth; financial conditions will remain fragile for some time. The longer the credit markets remain frozen, the deeper and wider the spread of economic contagion and the fear of a depression. The world’s financial firms have now lost $2.8 trillion as a result of the continuing credit crisis. To make matters worse, a number of sovereign states are having trouble obtaining credit – which has raised the odds of financial calamity in debt-laden developing economies – thereby suggesting that global policymakers are still behind the curve in terms of restoring confidence. Thus, although many financial assets look cheap, it may be premature to say that the worst of the equity and bond slump has passed.

On a positive note, the banking system and credit markets are starting to function again: LIBOR (inter-bank lending) spreads have narrowed substantially, counterparty credit default swap (CDS) spreads have tightened, and mortgage spreads are narrowing. Still, a propensity for banks to lend in the credit markets will be needed for investors to become optimistic. A highly volatile bottoming out phase is the most likely outcome in the current environment. Flight from all but the safest of government debt has left investment-grade company bond yields at a record 6 percentage points more than Treasuries on average while securities sold by government-chartered enterprises Fannie Mae and Freddie Mac yield an extra 1.5 percentage points, also an all-time high. While tremendous pockets of value have been created, it will take a while to rekindle risk appetites.

The S&P 500 fell -8.9% in September and is down -19.3% year-to-date. In addition, October will be one of the most volatile months on record. Global stock indices and currencies have been similarly turbulent, especially since Hungary and the Ukraine turned to the International Monetary Fund for financial rescue. The financial storm has hit the Gulf States too, with their banks stumbling on currency speculation, declining real estate fervor and falling oil prices (from the $140s in July to the mid $60s today). Continued severe financial stress raises prospects of a deep global recession: a 4% contraction in US GDP this quarter and a 2% contraction in Europe, deflation, and downward spiraling emerging market economies. At the conclusion of October’s two-day FOMC meeting, expect a ¼% to ½% cut in the target Fed funds rate.

Michael Ashley Schulman, CFA
Hollencrest Capital Management