So what happened at the end of February; China, Greenspan, subprime? Volatility, not seen since May and June 2006, hit the equity, commodity, and bond markets at the end of the month.

  • The Chinese equity markets fell a precipitous 9% on February 27
  • Alan Greenspan, at a Hong Kong conference, speculated a US recession in 2007
  • Investors feared a US financial crisis would precipitate out of a growing consumer subprime mortgage debacle

After the market fall in China, equity markets in Europe, the Americas and the rest of Asia dropped in sympathy. Investors reduced risk across asset classes, raised cash to cover margin calls, and put monies into government bonds. Although China and the US bounced back a little on February 28, Europe and most of Asia continued their downward drift.

Rumors caused the Chinese market to drop a precipitous 9% on February 27. Nothing actually happened or changed in China, but analysts speculate that the government may have wanted to remove exuberance from the market ahead of the annual Party Congress convening on March 5. Several rumors strained the market:

  • Capital gains taxes (there are none at present) “may be discussed” at the Congress
  • The current regulatory Chairman may be promoted to a new post and the next Chairman may not be as pro-market
  • Regulators may investigate financial capital flows and find dubious trading practices

In addition, oil futures bounced off of their recent $50 lows and moved back above $61. On the bullish side, 2006 corporate earnings should come in favorably over the next few months, capital flows are still increasing, and M&A and restructuring are strong.

Because mergers and acquisitions have recently helped raise valuations, fears that the volatile markets would cool deal making frenzy exacerbated the end of month slide of global equities. US financial stocks were additionally hit because of their exposure to the troubled subprime mortgage sector, for which banks (in order to protect short term profits) have not set aside enough reserves. Additionally, some analysts wonder if borrowers with average credit ratings will also struggle as adjustable rate mortgages and other unconventional teaser rates start ratcheting higher. Nonetheless, even with these consumer finance worries, February also saw the start of negotiations on a record large $45 billion takeover of TXU Group energy company.

Most analysts doubt Greenspan’s warning about a 2007 recession and rather fall into the Ben Bernanke camp that growth is good. Nonetheless, a relatively high number of US companies are guiding Wall Street expectations down with lower than expected profit forecasts. This could have negative implications for the corporate credit markets and cause a widening of spreads for corporate high yield and investment grade bonds; thus, corporate bonds would become cheaper.

Michael Ashley Schulman, CFA
Hollencrest Capital Management