November 2007

The impact of the subprime-induced credit crisis continued to take its toll during October. Markets tend to discount negative surprises quickly, under the expedient assumption that a problem acknowledged will also be dealt with.

While this comforting illusion implies a swift return to business as usual, it also ignores the potential longer-term effects of such phenomena. After many of the major global banks appeared to have exorcised the spectre of the subprime malaise with third-quarter reports that allowed for losses in that regard, investors responded positively. However, this relief seems to have been premature, and subsequent developments have confirmed that many leading banks have rather more risky credit exposure than had previously been thought.
 
Financial institutions and housing-related companies are the obvious victims of the ongoing credit squeeze. However, the more worrying question is how the broader US economy will be able to cope with a continued decline in the domestic housing market and associated problems in the credit markets. In particular, if the overall impact is one of significantly less consumer spending (already under renewed threat from record high oil prices), this bodes ill, not only for the US but for the global economy.
 
Lower growth is anticipated, yet the US may avoid an outright recession. The Federal Reserve has signally abandoned its inflation-fighting stance to alleviate this prospect by adopting an accommodative monetary policy. Other central banks (aside from Sweden, where special circumstances obtain) have followed suit to varying degrees. Recent US employment statistics have also been supportive, and a US dollar trading at record lows against the euro implies cheaper, more consumer-affordable, US imports. That said, there are risks to easing monetary policy in the current environment, not least those posed by rising food and commodity prices, which could result in inflationary pressures that will necessarily narrow the Fed’s range of policy responses to possible further deterioration in the credit markets going forward.
 
For now, bank stocks are bearing the brunt of investors’ frustration and uncertainty, and, with the security of all but the highest quality issuers and the very short end of the yield curve now in some doubt, the traditional safe haven of the credit markets has forfeited its relative appeal, allowing gold to make a comeback as the last refuge for panicky investors. It may be wishful thinking to believe that a meaningful slowdown in the US can be avoided but, as it is still impossible to predict the ultimate extent of the subprime meltdown on the overall economy, such an outcome is still credible.