Hedge Funds at the Center of Recent Volatility
As we ended the third quarter the U.S. equity market soared back into record territory seemingly ignoring one of the largest credit events in more than a generation. What caused the volatility in financial markets during the summer and was it “much ado about nothing”, or a real cause for concern?
Weak regulatory oversight and a relaxation of normal underwriting standards during what was a period of abnormally low interest rates created an investment environment driven by excessive liquidity.
With the global economy awash in “cheap money”,asset bubbles began to emerge, most notably in U.S. housing. Predatory lending practices lured “subprime” customers into adjustable rate mortgages with low initial teaser rates. By the end of 2006 there were nearly 8 million “subprime” mortgages outstanding valued at U$1.4 trillion.
Most of those “subprime” mortgages were packaged into derivative financial instruments called mortgage back securities (MBS) and quickly moved off the banks’ balance sheets where they can be easily monitored to other financial institutions and hedge funds where they can not.
The collapse of two Bear Stearns hedge funds both of which had exposure to “subprime” mortgages appears to be the catalyst that caused a re-pricing of risk and an unwinding of levered positions by other funds. As hedge funds dumped their positions, there was a massive flight to quality in fixed income markets, equities sold off, and credit market seized up. Central banks around the world intervened and provided liquidity to bring stability back to the market.
The financial system appears to be slowly working its way through the recent credit crunch. Unfortunately, for all of those troubled U.S. homeowners a cut in the U.S. overnight lending rate and a modest federal bailout program are unlikely to have much of an effect on the waning housing market. We feel the full effect of the meltdown in U.S housing and mortgage-backed securities will not be known for months.
Corporate earnings growth is likely to slow further as profits for financial services companies are revised lower. Profit growth could briefly turn negative and this could serve to put a cap gains in the U.S. equity market in the fourth quarter. However, the odds of a recession still appear low at this time as a weaker U.S. dollar is underpinning double digit growth in U.S. exports.
As for stock selection, we are buyers of defensive stocks including CVS Corp., AT&T Corp., Comcast, Edison International, Eli Lilly and United Health Care. With the pace of U.S. economic growth slowing relative to other developing markets, we encourage investors to build foreign exposure in their equity portfolios using mutual funds, Exchange Traded Funds (ETFs), American Depository Receipts (ADRs), and U.S. multinationals. Companies with strong franchises and overseas exposure include Proctor & Gamble, United Technologies, Luxxotica Spa, Nike Inc., Caterpillar Inc., Transocean Inc., and Cisco Systems. We believe a better entry point for financials will develop in Q4.