Global Markets Summary

Friday, February 27th, 2009 | Market Updates

‘Stop the world, I want to get off…’

The true cost of the sub-prime mortgage meltdown

2007 was the year in which the US sub-prime mortgage sector collapsed, triggering worldwide problems within the financial system. However, 2008 was the year in which governments, businesses and individuals became fully aware of the consequences of the sub-prime debacle amid the development of a worldwide credit crunch.

As the year progressed, investors and governments realised that the problems faced by financial institutions were even more extensive and serious than had previously been thought. Moreover, it became clear that these problems would not remain confined to the financial sector, but would affect almost every business and household. During 2008, confidence in the financial system has collapsed, share prices have plummeted and governments and central banks have striven to boost confidence in the financial system and kick-start lending activity.

A banking sector in disarray

The collapse of sub-prime and the subsequent credit crisis led to massive changes in the structure of the global financial sector, not to mention wholesale redundancies. JP Morgan bought troubled investment bank Bear Stearns in a deal underwritten by the US Federal Reserve (Fed), while American International Group (AIG) was bailed out in order to avoid the risk of meltdown in the global financial sector. However, 158-year-old Lehman Brothers was allowed to collapse in a move that shook the sector. Merrill Lynch was taken over unexpectedly by Bank of America, and venerable investment banks such as Goldman Sachs decided to transform themselves into ordinary bank holding companies in order to allow themselves the chance to benefit from Treasury funding if necessary. Meanwhile, in the UK, mortgage banks Northern Rock and Bradford & Bingley were nationalised by the British government and Lloyds TSB launched a takeover bid for HBOS.

Iceland hit the headlines in the autumn following a raft of bank failures that strained relationships between London and Reykjavik amid concerns that Iceland was refusing to guarantee the deposits of UK-based savers. This controversy, combined with Northern Rock’s collapse in 2007 and subsequent concerns about toxic debt within the banking system, triggered new debate about compensation schemes for savers.

Global stock markets experienced heavy losses

Financial markets experienced wild swings during 2008, and movements of four per cent in a single day were not uncommon towards the end of the year. The MSCI World Index fell by over 40% during 2008, and every major market experienced heavy losses, with the American stock market plumbing depths not seen for over five years. Corporate profits are under pressure; companies are cutting or cancelling dividends, and high levels of redundancies are swelling unemployment statistics as firms do whatever they can to cut costs, shore up their profits and stay afloat. Higher unemployment is likely to compound pressure on economic growth as consumers tighten their belts and stop unnecessary spending.

Propping up the financial system

Amid the financial and economic turmoil, governments and central banks have worked hard to prop up the financial system. After some political wrangling, the US agreed a rescue package worth US$700 billion intended to help bring back confidence in the financial system and encourage banks to restart lending activity. A subsequent package worth a further US$800 billion was agreed in November. The European Commission announced a spending plan to boost the eurozone economy worth €200 billion, while the UK government announced measures to help shore up the UK economy in its annual pre-budget report.

Interest rates tumbled

Interest rates provided some of the most dramatic headlines during 2008. UK interest rates began the year at 5%, and ended the year at 2% – their lowest level for over 50 years – amid growing fears about the risk of deflation and concerns about the worse-than-expected economic downturn. Meanwhile, American interest rates reached an all-time low of 0.25% as the Fed attempted to kick-start economic growth and control price stability. The Fed’s actions have increased speculation that the Bank of Japan might cut Japanese interest rates from their current level of 0.3%. Elsewhere, interest rates in the eurozone ended the year at 2.5%, but have been tipped to fall as low as 1.75% during 2009.*

So what will 2009 bring?

The International Monetary Fund (IMF) expects world economic growth to slow from 5% in 2007 to 3.75% during 2008 and to just over 2% in 2009, and this decline is likely to be led by the major economies. The IMF expects the UK economy to experience a particularly significant decline of 1.3% during 2009, while, the all-important US economy is forecast to contract by 0.7% next year. **

Although analysts still await official confirmation, the UK and US economies are widely considered to have fallen into recession some months ago, and this has already been discounted in share prices. Nevertheless, businesses, investors and analysts remain preoccupied by the possible length and severity of the recession, and are likely to keep a sharp lookout for evidence that the economy is either improving or deteriorating. As we say goodbye to 2008 and head into 2009, this uncertainty is likely to keep investors’ nerves on edge, and ensure that share-price performance remains volatile.

Sources:

* Bloomberg, 15 Dec 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=azuNjokrEk88&refer=home

** International Monetary Fund, 6 Nov 2008
http://www.imf.org/external/pubs/ft/weo/2008/update/03/index.htm#table1

Tags: Financial News, Interest Rates, Investments, Savings, stock markets