Tensions rising again in the markets

Allister Heath
WHEREVER one looks, there is danger in the air. Global equities are down 10.2 per cent in August and 11.3 per cent in the year to date. European and UK shares are down 13 and 10.4 per cent respectively in August, and 16.8 per cent and 11.5 per cent so far this year, Evolution Securities has said. Investors have lost faith in the cycle, in the authorities, in governments and in many firms, especially in the financial sector. Tensions are building in the credit markets, with spreads growing, risk aversion mounting and the cost of insuring debt rising. The Greek bailout is faltering, with countries demanding collateral; the European Central Bank is buying Club Med government bonds but there is no viable plan to resolve the crisis. It even seems to be becoming harder for at least one or two European banks to raise funds from the private sector and via the interbank lending market. US money market funds are significantly reducing their exposure to some European banks. Central banks are nervous and standing ready to provide more liquidity to the markets. The share prices of UK banks have plummeted.

Meanwhile, in New York, the price-to-book ratio of many large banks has fallen significantly. Instead of trading above book value, these banks are being priced at a huge discount. There may be nothing in this, and they may eventually bounce back; Bank of America’s shares closed up substantially last night following Warren Buffett’s stunning $5bn capital injection. But stock prices are being weighed down by investors’ worries about balance sheets, banks’ exposure to mortgages of the non-securitised variety, and by the possibility that several will have to raise further capital. Banks have also been hit by lower trading profits and litigation threats. Further recent declines in house prices and economic deterioration – jobless claims climbed by 5,000 to 417,000 yesterday; US GDP growth may be revised – are driving the concerns.

The real story is not whether the Fed’s boss Ben Bernanke hints in his Jackson Hole speech this afternoon that he wants to buy another $600bn worth of US government bonds, or decides to create the money to buy other sorts of assets in a blast of QE3. It is not even whether he will engage in an Operation Twist to manipulate the structure of interest rates, buying long term bonds to flatten the yield curve. Such policies would boost equities, hit the greenback, boost gold and affect credit markets – but will not address the underlying performance of the economy, which is suffering from too much debt and the need to continue to flush out the excesses of a crazy 15-year liquidity bubble, not from high interest rates.

The real story is whether the mounting tensions will eventually erupt uncontrollably, probably as a result of the incompetence, profligacy and idiocy of a European government, and trigger another major bloodbath, taking down countries, supranational bodies as well as financial institutions. Nobody knows whether we are a few weeks away from a severe crisis, or whether we will muddle through. It will partly depend on whether the authorities react sensibly, and whether they have the guts not to try and buck the market. While the global system is in some ways much weaker than it was in 2007-08, largely as a result of an explosion in sovereign borrowing, it is also much stronger in other ways. Only one thing is sure: it will be touch and go either way.

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