Comment: Too close to home?

Earlier this year it was the apparent vulnerability of Chinese stock markets and the yen carry trade that was spooking markets, but now it is the problems of the US sub-prime mortgage market and of structured credit instruments that are raising fears among institutions about systemic risk, say the strategists at State Street Global Markets.

Film director David Lynch has been dubbed 'Jimmy Stewart from Mars'. He has made a career stripping back the idyllic surface of small-town America to reveal an imagined dark underbelly. Films like Blue Velvet and the TV show Twin Peaks are unsettling because they juxtapose the familiar and comforting with the bizarre and frightening, white picket fences and homecoming queens with severed ears and owls that 'are not what they seem'.

Financial markets are often portrayed as the epiphany of globalisation. Everything is interconnected. A sell-off in the domestic share market in Shanghai on February 27 caused trillions to be wiped off share values worldwide. A surge in US government bond yields a fortnight later triggered a similar, though less extreme, reaction. On both occasions, stock markets recovered. But this week something closer to home seems to be unnerving them, the woes in the sub-prime mortgage market and its knock-on effects in the strange world of structured credit.

However, old issues have not gone away, nor has bullishness evaporated. The carry trade is as ubiquitous as ever - pushing the yen to a four-and-a-half-year low against the dollar and to its lowest level against sterling since the aftermath of 'White Wednesday' in September 1992. Shanghai's bourse is still a bubble, one with several fresh record highs under its belt since February, the latest in this past week. Stocks markets from Seoul to Sao Paulo have risen into record-breaking territory.

These market moves have been supported by risk appetite and cross-border institutional equity investment. Over the past 60 days, a period that encompasses a pot-pourri of Chinese wobbles and bond market jitters, the Cross-Border Equity Flow Indicator shows record buying of developed markets and the eurozone. Flows into emerging markets are also robust, in the 87th percentile (only higher on 13 percent of previous three-month periods in the history of the indicator). The only region where flows are noticeably weak is Latin America.

It is clear that a significant asset allocation shift has taken place in institutional portfolios, particularly over the past month. Rewind to February and the overwhelming consensus was that the Federal Reserve would cut rates, perhaps even twice, before the year was out. Economic data in the second quarter, such as stronger than expected May retail sales, mean any rate cuts are now off the agenda.

With a soft landing on the cards, US equities are all the rage. In contrast, foreign flows into Treasuries have collapsed. The fortunes of the dollar have recovered in tandem. Short dollar was a big consensus trade at the start of the year when the US economy looked set for a rocky ride. In mid-January 120-day cumulative US dollar flows dipped into the fifth percentile (flows were higher on 95 percent of previous six-month periods).

That short position was eliminated three weeks ago and flows are now in the 56th percentile, the highest since October last year. Where institutional investors have led, the speculative accounts tracked by the CFTC's IMM survey have followed, buying USD10.9bn of US dollar contracts in the last week of recorded data. This has reduced the aggregate short position of speculative investors to the smallest since March.

Institutional investors in equities have timed their sector allocation shifts just as well. One indication that they were concerned about the turning credit cycle is that flows into the global financials sector turned negative on April 6. Within the financial sector, the most marked selling is of the thrift and mortgage finance industry group and selling of the capital markets group has accelerated in the last week.

This data is up to June 19, so it predates the worst of the headlines emanating from the meltdown of two US hedge funds with large exposures to collateralised debt obligations and other structured credit instruments. CDOs and CDOs-squared are like bonds designed by David Lynch, familiar yet somehow not. Rather like Lynch's films, only true initiates can truly claim to understand what is really going on in their inner workings.

Financial innovation was never going to be a risk-free lunch. No matter how clever the instrument, in investment there is always a winner and a loser. So far, the fallout seems to be contained in a tiny cul-de-sac of the market. But institutional investors are clearly nervous about systemic risk and a possible replay of the events of 1994, when rising rates triggered high profile hedge fund collapses and the implosion of the nascent mortgage derivatives market. Something much closer to home may yet prove just as unsettling to investors as the exotic risks emanating from the yen carry trade or the Chinese asset bubble.

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