Global stock markets have lost about 6,5% from their peak in mid-July, with levels of volatility not seen since the 1997/98 emerging-market crisis and the credit-market crisis of 2002/03 led by the collapse of Worldcom and Enron.
Just prior to this market fall-out, the International Monetary Fund (IMF) revised global growth expectations for 2007 and 2008 from 4,9% to 5,2% — a significant revision, given that the world has been growing at only 3,5% on average for the past 50 years. Also significant was the fact that this upward revision was done while lowering expectations for growth in the United States to only 2% for the year.
Despite lacklustre growth in the developed world, government and corporate investment (in infrastructure and human capital development) and buoyant consumer demand in developing countries have led strong global economic growth. Spurred on by this global growth momentum, supported by corporate profit margins which are at 40-year highs and with share prices still at reasonable levels considering strong company earnings, the global stock markets were able to continue on the rising trend of this four-year bull market.
In mid-July, however, equity markets began to wobble, sparked by fears of financial system collapse from the overextended US mortgage market.
With the US Federal Reserve Bank having raised interest rates steadily in the past three years from a low of 1% in mid-2004 to 5,25% currently, economists and market participants began to raise concerns that borrowers in the US housing market would begin to feel the pinch.
Although housing inventories began to pile up at the beginning of last year and the balance sheets of home-loan lenders turned cashflow negative, it was only in the past month that financial markets began to price in this risk.
When corporates borrow money from the bond market, investors demand a return (known as a spread) above the government’s treasury interest rate, a rate that is seen as risk-free as one doesn’t expect the government to default on its debt.
Typically, a large, stable company would pay a spread of 0,25 % above the treasury bill rate. With concerns that the high interest rates would begin to squeeze borrowers in the US mortgage market, these corporate credit spreads increased three-fold in the second half of July to levels not seen since the Russia crisis in 1997, the Asia crisis in 1998, the long-term capital management crisis — that saw the 14 biggest banks in the US almost close down — and the credit crisis of 2002/03 that was sparked by the Enron/Worldcom debacles.
While these concerns are justified in the low-grade sector of the US mortgage market, where home-lenders extended credit to borrowers with impaired credit histories, this panic was simply not justified in the high-grade corporate sector, where balance sheets and earnings are strong.
Encouragingly, since the blow-out these high-grade corporate credit spreads have now reduced by half, but global equity market participants remain cautious and markets volatile.
Given the fundamentals of strong global growth (especially in emerging markets), solid corporate balance sheets (excluding the sub-prime home-lenders), healthy earnings growth and reasonable equity valuations, these market sell-offs present value and good buying opportunities — as long as you can stomach the daily volatility.
Réjane Woodroffe is chief economist and head of international portfolios at Metropolitan Asset Managers