In the eye of the credit storm

Since the recent rollercoaster ride in credit and equity markets, punctuated by regular breaking news on yet another collapsed or distressed fund or company, the past week or two has been relatively quiet.

Has the storm passed out to sea, leaving investors a bit bedraggled but still standing? Or is this just the eye of the storm, with worse to come?

It seems that equity market analysts are looking forward with enthusiasm, eager to move on after a largely positive reporting season, with confidence in the ongoing commodity boom.

Many economists, however, are still debating whether catastrophe will strike this year, in 2008, or in a few years’ time.

They do, unfortunately, seem to agree on two things — that a crash is bound to happen sometime, it is just a question of when; and the later it happens, the worse it will be.

Having built rather comfortable lifestyles on the back of readily available credit and job security from a strong employment market, and with many people never having experienced a recession, we suddenly find ourselves being lectured about sensible behaviour. Rather like blocking our ears to mum when we were teenagers, we’re not likely to listen until we need to, and then perhaps we might wish we had taken notice earlier.

I am not a pessimist, but I can’t help think that it might be prudent to stop and take stock, and who knows, we might be able to get through this after all.

So, the question is: where exactly are we in the credit crunch? In the eye of the storm? Or has it passed over?

In my view, there is more to come. The issue is timing — whether the outer rim of the cyclone is going to hit later this year; in 2008; or later.

So far, what we’ve seen is distress in limited sectors of the personal credit area (housing) and the finance sector.

We haven’t yet experienced the full play-out of the ripple effect of these events.

The first ripple was the rating agencies downgrading past issues of credit securities.

In late July, more than half the US corporate bond market was rated by Standard & Poor’s as “speculative” or, in more direct words, “junk”.

Now less attractive to both holders of these securities, and potential buyers, the price of these securities fell dramatically.

As a result, the market generally began avoiding the lower rated securities, and the second ripple is the rush to high quality AAA securities.

But those who have them are not easily letting go, unable to pass off their less attractive credit, they’re hoping to cling to their finery.

Next, the rating agencies, seeing risk in a new and more realistic light, are starting to rate new issues of credit more conservatively.

Credit by necessity will become more expensive. And again, the now wary market will be less interested and less able to buy as it can’t liquidate their other fixed interest holdings.

So, the market will start to dry up. And this is where life could become a bit more precarious.

We all still need liquidity, and if people can’t get it through their lower rated securities, they’ll need to reach onto their top shelf and start selling their top-rated stock, exacerbating the problem.

Importantly, these top rated security issues rely on lower rated securities.

While it is good for the market to have a dose of reality, the concern now is that investors will over-react as the market corrects what has been a 25-year bull run in the fixed interest sector.

So why is all this important? Isn’t this just boring stuff for dusty bond people to discuss when trying to wring out that last basis point of return?

The relevance is that this is the essence of our economy and those ripples will start to affect us all. It is not simply the interest rate on people’s mortgage (although that’s obviously something that grabs people’s attention pretty quickly).

Some of the additional effects include the following.

> Debt becomes more expensive. Corporations have been relying on debt to fund the growth of their business. Those very healthy projected earnings support a higher stock market price.

More expensive debt could lead to more conservative growth agendas, a reining-in of the share price and, potentially, a reduction in their labour force.

> One of the biggest creditors today — in addition to individuals and companies — is the finance industry. It has become increasingly clever at securitising assets into complex structures that enable investors to push for higher returns while seemingly enjoying the lower risk of bonds.

But you can’t cheat the laws of risk and return this way. It looks likely that any enhanced return achieved to date may simply have been the forward payment of what should have been tomorrow’s more modest returns.

That leaves tomorrow’s returns looking a little dismal. And a lot of people wondering how exposed they may be directly (through investment in such structures) or indirectly (through investments in or with companies who may be forced to underwrite potential losses across their structured credit funds).

This is all fairly depressing, but let’s look at what could help us.

> The Federal Reserve is playing a clever game, employing finesse in providing liquidity for the areas that require support (for example, cutting the rate at which the banks can borrow from the central bank) without using the more blunt instrument of monetary policy (that is, cutting the cash rate). It has a challenge ahead, but it just might be able to pull the US out of the hole. What should help too is the weight of money Asia continues to invest in the US — as they exit US shares they are buying US currency.

> In Australia, we have a strong commodity market, supported more by Asia than the US. As long as as the Chinese or Indian economies can be insulated from any deterioration in the US (and there are arguments why this could be the case), and continue their demand for our products, then Australia stands a better chance of also decoupling its economy (if not its market) from what could be a worse story in the US. We also continue to have superannuation money seeking a home, albeit perhaps a safer home than before.

Ironically, though, if we pass through this period relatively unscathed, we should hope that the memory lingers and saner minds reign.

Having credit confidence boosted higher from surviving this wake-up call could be the very thing that tips us into disaster.

My view is that 2008 is probably the year we will see things get messy.

Rather than venturing out sighing with relief that they have survived, either from prudence or good luck, investors should bunker down and ensure their fixed interest investments are defensive.

Kirsty Dullahide is head of strategy and portfolio management at Australian Unity Investments .