Stuck in safety first

On successive Sundays last month the US financial system stood on the brink. Instead of relaxing with friends and family, bankers have been in their offices assessing counterparty risk. The one certainty as this is being written is more uncertainty.

Perhaps the only crumb of comfort in an otherwise dismal market environment is that institutional investors have been well positioned for the latest swoon. State Street Global Markets' regime map shifted to the conservative safety first regime in June and has stayed there ever since. This is the most sustained period of risk aversion since the start of the credit crunch. Last year two months of safety first in July and August were followed by four months of riot point, the most risk averse regime.

Given recent tumultuous events only the foolhardy would confidently predict that 2008 will not see a replay. Other than remaining in safety first, a shift to riot point is the most likely move in the map based on prior history. It is too early to say how the bankruptcy of Lehman Brothers will affect investor behaviour, but it is unlikely to inspire a bounce in risky assets. The bail out of Fannie Mae and Freddie Mac was good news by comparison, yet flows in the following week remained decidedly anaemic. 

The relief rally following the nationalisation of Fannie and Freddie lasted all of one day. Without support from institutional investors the short-term run up in markets from the July lows was always destined to run into a brick wall. Equity prices have throughout been a poor guide to the credit crunch. It is remarkable to recall that US equities actually hit a new record high in October last year.

Institutions were on the sidelines then and remain there now. Nothing the authorities did last winter worked. Three cuts in the fed funds rate (and four to the discount rate) did not change sentiment. In a credit crunch it is not the cheapness of money that matters, it is its availability. Only the Bear Stearns rescue in March did the trick. Investors started to buy cross-border equities aggressively.

In retrospect, this probably said more about the macroeconomic backdrop than confidence that the credit crunch was over or the financial system safe. The headlines then were dominated by fears over inflation. The longer the credit crunch continues the more deflationary it will prove to be. That reality seems to have finally dawned on overheated commodity markets. Oil has slumped to less than $100 a barrel having briefly touched $147 in June. 

But this is not just an oil story. The CRB index has fallen 24% in a ten week period the most rapid reversal in this benchmark in its 40-year history. Natural gas has plunged 45%, copper is down 25% and in spite of the worst UK harvest grain farmers can recall, wheat is 20% lower. Inflation expectations have also dramatically reversed. The 10-year US TIPS is now trading at levels last seen in 2003 when former Fed chairman Greenspan was (erroneously) fretting about deflation. 

Interest rate expectations have also adjusted. Until recently markets believed the next move in US rates would be up. That is no longer the case and more cuts are now expected this year. This is one piece of good news. The Chinese have already surprised by cutting the one-year lending rate 27bp. With clear signs of growth stalling and inflation moderating, they will not be the last central bank to begin easing. So far the US and Canada have been the only G7 economies to cut rates this year. If cheaper money becomes a global phenomenon it might encourage investors back into equity markets.

However, with the news from economy, financial sector and housing market so relentlessly gloomy it seems unlikely there will be a change in sentiment in the short-term. In this environment the strategy teams at State Street Global Markets continue to adopt the cautious stance called for in a safety first regime. In foreign exchange that means maintaining a long dollar position and avoiding the high yield value trap.

In equity markets the deflating commodities bubble prompts an underweight recommendation in energy, industrials and materials. Institutional investors are selling and timed the paring of their positions to perfection. The reversal in flows almost precisely coincided with the peak in the oil price in July. These three sectors have a similar profile now to telecoms, media and technology in 2000. Not only are they expensive relative to their history, they have also pushed aggregate earnings across the market to well above trend. When reversion to mean bites, it is the former market darlings that tend to be particularly hard hit. 

In spite of all the frenetic activity over multiple weekends, investor sentiment shows no signs of turning. If it deteriorates further and the regime map flips back to riot point, a bad year for markets could yet turn uglier. The mood would certainly improve if a few weekends passed without incident. With the credit crunch enduring bankers and regulators might be better off returning to a more traditional Sunday pursuit: prayer.