September Market Commentary: Markets Still Coping with Widescale De-Leveraging
Passage of pending bailout package may help calm financial markets
Cathy Roy, CFA, Calvert Chief Investment Officer, Fixed Income
Natalie Trunow, Senior Vice President, Head of Equities
Calvert Asset Management Company, Inc.
Today’s bounce off the bottom notwithstanding, we are in the midst of one of the steepest stock market drops in 20 years, a decline that reflects the ongoing, painful process of de-leveraging, or unwinding the layers of cheap debt that have driven the economy and financial markets in recent years. Current market volatility is spurring investors to flee riskier assets, such as equities, and pile into traditional safe havens, including gold and short-term U.S. Treasuries. Higher beta (higher risk) asset values have deteriorated the most.
Within the U.S. financial sector, decreasing profitability, increasing competition and the prospect of another wave of asset write-downs, this time at regional banks, are among the key issues roiling equity markets. Europe, too, is going through the process of trying to save its troubled financial institutions, with firms like the U.K’s Bradford & Bingley and Hypo Real Estate in Germany expected to get bailouts.
Rescue Package Needs to Include Complex Securities
Globally, the immediate, overarching concern is that the proposed U.S. financial rescue package, which Calvert expects to be revived and passed in some form, may not be enough to resolve the deep problems in the financial sector, let alone get capital markets back on track.
Still, while we are not convinced that the $700 billion will adequately strengthen the financial system, it may be enough to calm the markets. Current proposals appear to involve a tiered approach that addresses less complex mortgage-backed securities first. However, unwinding of the more complex securities,such as collateralized debt obligations and collateralized loan obligations, which have the greatest embedded leverage, will continue to feed the de-leveraging spiral.
This week’s spike in the market volatility as reflected in the VIX Index is signaling that we may be approaching a “capitulation” in the equity markets or signs of a bottom.
Watching the “TED spread”
In fixed income markets, there is considerable market concern following the Lehman Brothers bankruptcy about where losses on credit default swaps (CDSs)--which are over-the-counter contracts that some market participants use to transfer credit risk--may crop up. None of Calvert’s fixed income funds have any CDS exposure.
During this volatile period, the Federal Reserve is doing its best to pump liquidity into global markets. This week it announced plans to pour an additional $630 billion into the global financial system to help settle the markets and, hopefully, restore trust among the banks. The Fed also has increased its Term Auction Facility, from $150 billion to $250 billion, to boost market liquidity.
At Calvert, we are keeping an eye on the “TED spread,” which provides an indication of banks’ willingness to lend to each other. The spread is the difference between the three-month LIBOR (London Interbank Offered Rate), the interest rate at which large international banks are willing to lend each other money on a short-term basis, and the yield on three-month U.S. Treasury bills. Currently, the TED spread is the widest it’s been in 25 years, reflecting the banks’ considerable anxiety.
Not surprisingly, the House rejection of the proposed rescue package yesterday resulted in a massive flight to quality in fixed income markets, which drove down one-month Treasury bill yields by 0.55 percentage points, to 0.30%.
The more enduring problem may be that with passage of a rescue package, the price assigned to troubled assets the government acquires may cause additional write-downs at financial institutions and a corresponding need to raise capital.
A Question of Confidence
Important risks to the financial system remain. However, in addition to removing “toxic” illiquid securities that are clogging the financial system, the pending rescue package is an effort to restore confidence in the markets, making banks more comfortable lending to each other and to consumers. We hope that, just as a lack of confidence has rippled through financial markets, momentum associated with even a modest improvement in confidence will help stabilize financial markets.
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