It feels awful out there…trust us, we know. We’ve cancelled all summer plans to remain in the office to mind this market even though with 500 point Dow swings it is difficult to know exactly what to do, if anything (we wonder why Obama and the EU leaders haven’t done the same, instead choosing to put lotion on each others’ backs in some exotic warm locale). With volatility like this it is easy to make a mistake so we monitor, take advantage of dislocations and try to understand where things are headed. For many investors, however, it's easy to draw parallels between this market and 2008 and there from comes the volatility we are seeing. We don’t believe this period in the worlds’ economies or markets is anything like 2008 (or 1974 for that matter) and there are a number of indicators that tell us otherwise.
For example, if we look at the 2Yr USD Swap Spread chart below Courtesy of Bloomberg (a measure of fear over the financial health of banks)– it is clear that professionals in the global credit markets (as opposed to the retail investor in the US Treasury markets) do not believe this is 2008 all over again. The current 2 year USD Swap Spread, which ballooned to nearly 170 bps in the fall 2008, still hovers at a slightly elevated 29bps—it’s hardly a blip in the chart. We aren’t even where we were at the end of 2010 in terms of fear regarding the financial system. Remember, 2008 was all about the fear of every US Financial Institution being insolvent and/or under-capitalized. And we did have real defaults... remember CIT? That was true credit risk.
At the moment what it appears is that we are dealing with is a global sovereign/currency crisis, which requires large-scale solutions: Eurozone fiscal unity; Chinese participation in the EFSF, etc. Of course, some economists are talking about the possibility of breaking up the Euro, however, even the Germans (who get almost 40% of their GDP from exports) are vitally aware of the implications of operating once again under the Deutsche Mark. If we do some overly simple math we see that Germany can easily lose as much as €300Bln in exports every year if that were to happen. Compare that to their current peripheral contribution to Europe? It makes it look like peanuts. In any case, if Greece, Portugal and Spain collapse; then Germany is already on the hook. And the there are the German, French, Italian banks -- no one wants to see this happen and they aren’t going to let it.
We hear rumors daily—for example, on Thursday some small unknown Chinese bank supposedly stopped doing business with SocGen—it was false and certainly benefitted the rumor monger as it dropped the futures 200 points alone in just 10 minutes (of course the futures recovered and we had a nice day—hope he/she lost his/her shirt)—but most of these are just plain false. Yet while many of these fears/rumors are unfounded, the volatility they create is not helping to improve trading liquidity. Furthermore, the liquidity that the Central Banks are pumping into the markets is losing its benefits as investors take it for granted. It is clear that the global economy is slowing, and risk is being re-priced. But that doesn’t mean one cannot make money in stocks. In fact, as we have all seen over the last 3 years, the pendulum can over swing both ways until sanity prevails. At the moment, we believe risk is being overpriced and will return to normal slowly but in short order.
The good news is that right now our markets are functioning: $10Bln in new corporate bonds priced last week alone as companies took advantage of negative real interest rates to clean up their balance sheets. That's an important data point. It means that investors still have cash to put to work and issuers can still come to market. It also means that Corporate America is getting healthier and while dislocations such as negative real rates can persist for a time, the bond markets and, most likely the equity markets, have overreacted and we are due for a reversal. This morning Japan reported much better than expected GDP. And we have only seen upward revisions to S&P 500 earnings projections since earnings season. No, this is not 2008 although it may feel like it. We suggest you turn off the financial news, enjoy your summer vacation and let the capital markets quiet down and sort themselves out. They always do—even post 2008.
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