Credit concerns and the effect on global stock markets

As an investor in stock markets both locally and abroad, I am concerned with the recent dramatic downturn in world markets. What are the reasons for this and should investors be increasingly nervous or hold tight?

Economic fundamentals remain good, with corporate earnings and global GDP growth both robust and equity valuations fairly priced. When the current sell-off is over, there will be value to be found. But what are the reasons for the current market crisis?

A sharp increase in mortgage borrowing costs in the United States, combined with large areas of negative equity (e.g., in Florida condominiums) has meant that lenders to the US mortgage market have been hit by a dramatic rise in mortgage defaults.

In the past, this might have been a local problem. But today's global markets mean financial institutions around the world have been able to buy up the loan books of lenders to the US mortgage markets, so that the effects of defaults are felt across the globe.

As one part of a bank's investment portfolio suffers, its willingness to take risk in other parts of its business falls sharply. So it demands a higher rate of return for making new loans across the board.

What is happening in the credit markets?

It may be that financial institutions simply refuse to lend money because they are unwilling to take on more risk in this uncertain climate. But this can cause severe problems to those dependent on short-term borrowing to finance long-term positions as illustrated in the example below:

You have bought a house on a two-year fixed rate mortgage. You envisage remortgaging every two years to get the best rate for the duration of the 25 years you anticipate it will take to repay the loan.

However, at the end of the two-year fixed rate term, you find that you are either having to remortgage at much higher levels than expected or, if the asset (your house) is perceived to be a risky asset (e.g., a house suffering from subsidence), you may find it almost or completely impossible to remortgage.

You may then be forced to take up your lender's extremely expensive variable rate or, if the bank considers its exposure to be too great and demands foreclosure, you may be forced to sell your asset. As you and others become forced sellers, the market for the asset weakens further, making it harder for others with the same type of asset to remortgage.

This is a very simple analogy to explain what is currently happening in the debt and credit markets. Risk appetite has been greatly reduced, and the rate of return demanded by lenders has significantly increased as they demand greater compensation for the risk they are taking on.

Companies seeking to refinance their debt are finding that the costs of borrowing have risen dramatically, and in some cases there is simply no willing lender.

Why is this affecting equity holdings?

Equity markets are responding directly to two themes:

1. They rely on market confidence. If one part of the financial market suffers, the willingness of investors to take on risk in other areas is curtailed. Indeed, high-quality liquid stocks may be sold to cover losses elsewhere.

2. In the leveraged buy-out (LBO) debt markets, interest rates demanded by purchasers have risen dramatically in recent weeks. Lenders financing private equity buy-outs are extremely nervous of not being able to get the debt onto the secondary market and instead having to hold it themselves.

This has effectively halted new deals and put under the spotlight existing deals in the pipeline. Hence, any company that had been a potential target for a private equity buyout has fallen particularly sharply as the bid premium has unwound.

What should I do with my money?

For those with existing positions in equity markets, I recommend holding tight. The difficulty of correctly timing a re-entry into equities mitigate any potential benefit of a short-term switch into cash.

Furthermore, while no one can predict the bottom of the current falls, it is clear that many securities have been pushed well below fair value. Selling at these levels may mean taking needless losses - those investors that have the ability to ride out the current volatility may be rewarded in the long term.

(Source: J.P. Morgan Asset Management, August 10, 2007)

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 or e-mail mh@hollingsworth-int.com

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Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.