The action in world markets over the last eight weeks has been unusually volatile with significant downward pressure on prices of both equities and non AAA rated bonds. It seems that the market has gone into panic mode. You can almost taste the fear out on the market floor. But what has changed since mid-July when the world seemed to be ambling along quite nicely?

The single most important ingredient to the success of the modern capitalist financial system is confidence- David Curmi

The simple answer is a lot. The realisation of the gravity of the challenges ahead combined with what looks like a piecemeal approach to solving the sovereign debt problem by politicians, led to the evaporation of confidence from the financial system. No matter how complicated the financial system may appear, the single most important ingredient to the success of the modern capitalist financial system is confidence. Take this away and no bank, financial company or economy can function efficiently. This loss of confidence transmits itself into falling prices of bonds and equities, and from there into the real economy.

As bond prices fell, and therefore the yield on the bonds rise, the spread in yields (i.e. the extra yield premium demanded by investors to invest in a bond that is not AAA rated) increased dramatically in August. Essentially for an investor to buy a BBB bond he is now demanding that it gives him four per cent more than what he would earn on a comparable AAA bond. This is up from approximately two per cent just before the market turmoil.

Similarly the increase in the spread on A rated bonds is from one per cent to just over two per cent. At the height of the crisis in 2008/9 the yield on BBB bonds reached 660 basis points (6.6 per cent) while on the A rated bonds the spread reached a peak of 490bp. Clearly there are different dynamics at play.

Firstly it is the move downwards in the yield on AAA bonds over this period. The average yield on 7-10 AAA bonds is today at approximately three per cent versus the almost six per cent at the peak of the crisis. Additionally it is mainly the prices of financial related bonds that have moved most aggressively this time. Non-bank bonds have held up significantly better than bank bonds. This is because the eye of the storm can be found within the financial system rather than the economy at large.

The move in equity prices was naturally much more pronounced. Equity markets have collapsed by between 12 per cent and 25 per cent since the beginning of August.

In comparison, the Malta Stock Exchange has been steady as a “rock”, falling just 4.4 per cent over the same period, whilst the local bond market displayed a similar level of steadfastness despite the Moody’s downgrade. Whether this is due to a lack of liquidity, an ability to price investments better or a better understanding of world issues is not the point at this junction!

What is the point and perhaps most concerning is that loss of confidence is like a transmission mechanism that once set in motion is more difficult to reverse. Unless checked, the lack of confidence will lead to lower spending, be it consumer spending or investment spending.

Companies and households have spent much of the last two years paying down their debts whilst at the same time benefiting from lower interest costs due to the lower interest rates. Yet they remain reluctant to spend. Until such time that there is greater clarity on the current sovereign debt problems there is unlikely to be a significant change in this attitude. In times of crisis it is normal human nature to horde, especially cash!

Here, greater political leadership is needed, not just political rhetoric. Action is needed that provides a solution so robust that doubts about its viability do not surface. So far this has not been the case but perhaps, following the IMF’s annual meeting at the weekend a realisation of this is taking place and a possible solution could be proposed. While it appears that Greece may be allowed to carry out an “orderly” default, plans to backstop contagion into the banking system look to be on the cards.

This could help stem the loss of confidence short term. In the longer term however, any plan would need financing, something which has brought about significant difference of opinions in Europe. Therein lies the risks. As I once read on a racing driver’s T shirt – Sit down, buckle up and hold on tight. We’re in for a ride!

Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Any opinions that may be expressed here above should not be interpreted as investment advice, nor should they be considered as an offer to sell or buy an investment. The company and/or the author may hold positions in any securities that might have been mentioned in this report. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

www.curmiandpartners.com

Mr Curmi is managing director of Curmi and Partners Ltd.

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