August 2007

Towards the end of July, a fundamental readjustment of investors' attitude to risk took place.

This sentiment shift wreaked havoc not only in the lower echelons of the bond market but also on an equity market that had been largely driven by expectations of further M&A activity, as the perception grew of an end to easy buyout financing. At the same time, and indirectly connected with these developments, the Japanese yen strengthened significantly, as many investors felt concerned enough to cut back on carry-trade activity.
 
At one point, it looked as if many of the concerns we have addressed in previous editions of Strategy Monthly this year had all decided to resolve themselves at once. Worries such as the fallout from the collapsing US subprime mortgage market, itself the result of an imploding domestic housing sector, have been there for some time, but investors were reluctant to take notice of it. Similarly, the dubious quality of some sophisticated credit derivative products went largely ignored until hedge funds began to run into trouble. Furthermore, the persistent weakening of the low-yielding Japanese yen had also been well documented in the financial press.
 
So, why has it taken markets so long to react to phenomena that seemed bound to happen sooner or later? The short answer is: psychology. Despite a superficial pretence of rationality, underpinned by an obsession with statistics, the market is largely a world dominated by internal sentiment and expectations. This can result in a state of wishful thinking, or disbelief, that becomes increasingly vulnerable to shock and disappointment. With regard to the most recent developments, many investors, while acknowledging the existence of the above-mentioned concerns, clearly did not want to believe that they might actually come about. After all, times were good and there was money to be made; it takes a lot of courage to be the first to leave the party if others are still having fun. When reality finally bites and disturbs the market's equilibrium by questioning its expectations, the adjustment to the new environment is usually swift and violent, as the "herd mentality" kicks in and everyone heads for the exit at the same time. 
 
At the time of writing, the debt markets are still reeling from growing fears of a credit crunch; credit insurance (the cost of protecting a basket of debt) has risen to record levels in the riskier areas of the bond market. In the foreign exchanges, the yen remains extremely volatile, but with a rising trend. However, equity markets have been relatively quick to adjust, notably in Asia. Overall, near-term prospects remain cloudy, but investors should probably brace themselves for more volatility in the weeks ahead.