The stock market turmoil that has recently wiped some 5 per cent off share prices speaks volumes about the fragility of global capital markets and investors’ changing attitudes to risk.
The big sell-off, seemingly sparked by a slump on the Shanghai stock exchange, hit Wall Street on 27 February and rapidly spread other bourses around the world, including the London Stock Exchange.
Many reasons have been given for the rout, including the near 9% crash on the Shanghai stock market the previous day. This was itself prompted by talk that the Beijing government was looking at ways of pricking the speculative bubble in Chinese equity values through the introduction of a capital gains tax.
Other reasons given have included the warnings of US recession from retired Federal Reserve chairman Alan Greenspan, the weakness of the US housing market and the implosion of the country’s subprime mortgage market. Jitters over Iran’s nuclear programme and the recent rebound in the oil price have also been blamed.
It does seem strange, however, that the finger of blame has been pointed in so many different directions. Might the reality be that nobody really knows? Or could there be another reason?
Some commentators are now suggesting that “Grey Tuesday” was in fact the consequence of some investors’ realisation that the four-year bull market is nearing its peak. The Economist recently suggested, investors were simply looking for “excuses” to take profits. The thinking behind this notion is that recent impediments to a widespread form of market chicanery known as the “carry trade” lie behind the recent market “correction”.
The carry trade has been one of the investment phenomena of the noughties. Perhaps more than anything else, it has fuelled the bull market in equities. What carry trade investors, including hedge funds and private equity players, do is essentially to play one country’s interest rate off against another’s.
So they will borrow vast sums in places where interest rates are low (such as Japan, where the benchmark rate is 0.5%, and Switzerland, where it is 2%). They then invest the money they have borrowed in high-yielding financial instruments elsewhere in the world, such as shares in UK companies that have generous dividend policies, emerging market debt, securitised parcels of subprime debt, often packaged into opaque bundles called collateralised debt obligations and junk bonds.
However seven of the world’s developed nations, the G7, recently decided something had to be done about the $1 trillion carry trade. The shrinking value of yen (a direct consequence of the amount of yen being borrowed by carry traders) had become a matter of grave concern, and they decided the time for government intervention had come.
It was not long before the medicine started to take effect: the value of the yen started to rise again, and many investors began to recognise that risk had not, after all, been eliminated from the financial markets. Many decided that, if a major source of the liquidity that had been propping up global share prices was to be taken away by those pesky G7 boys, it was as good time for a spot of profit-taking.
Whatever the reasons for the current stock-market gyrations, their implications for the UK housing market are hard to read. Provided the recent equity downturn turns out to more of a “blip” than a “crash”, and the Bank of England’s monetary policy committee holds its nerve on inflation and does not get too heavy-handed with interest rate rises later in the year, the housing market will probably continue its seemingly inexorable rise.
However if this turns into a full-scale market meltdown along the lines of what we saw in 1929, 1987 and 2000, then the Bank of England would almost certainly react by slashing interest rates (as it did in 2000). This would of course stimulate property market activity. But even with much cheaper money, nobody should assume that the house market would be immune from collateral damage.
Against the backdrop the MPC’s March decision to hold UK interest rates at 5.25% was a welcome call, and forecasters are still predicting that house price inflation will be in the region of 9-10% this year. The International Monetary Fund recently said: “In the short term, forward-looking indicators of housing market activity suggest that house price growth is likely to remain elevated.”
However the New York-based IMF went on to say that soaring UK house prices “warrant vigilance”, adding: “In the light of estimates that house prices are already overvalued, this would increase the subsequent risk of an abrupt downward adjustment.”
Just like the carry traders, perhaps it’s time that housing market professionals started to recognise we no longer live in a risk-free world.
This investment column was published in The Estate Agency Times on 12 March 2007