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Crunch decisions

Fresh concerns about the health of the US financial system have knocked stockmarkets off the highs they reached in mid-July. Once again, the epicentre of the crisis is the sub-prime loan market, with knock-on damage in securitised credit, high-yield bonds and leveraged loans.

It is impossible to know exactly where the investment losses lie and how great they are. However, investors are taking no chances. Anything that could be exposed has been marked down sharply and sometimes seemingly indiscriminately. To date, the correction in the market looks like another fast and furious derisking by hedge and investment banks rather than the early stages of a bear market.

The last time the markets faced the prospect of a credit crunch in 2000-01, corporate balance sheets were laden with debt. Previously, in 1998, a short-lived credit event was accompanied by Asian companies and nation states including Russia defaulting left, right and centre.

Other factors distinguish current conditions from these earlier periods. Valuations are not aggressive in most areas of the markets, balance sheets are strong and earnings are coming in ahead of expectations. Bond yields have fallen, offsetting a good chunk of the widening in credit spreads.

On balance, we currently see no need for the economic cycle to end. That said, it is not clear what will restore calm. No doubt there will be some real economy impact coming out of this mess but we believe global monetary policy is still no worse than neutral and that is more likely to define economic conditions than the fall-out from sub-prime. It is also clear that the Federal Reserve is ready to lower interest rates if that is required.

Capital destruction is the biggest threat to the markets from here but we believe underlying conditions are not right for that to come about and, on a more speculative note, we wonder if the Chinese will accommodate a severe market downturn in party congress year and the US authorities in a pre-election year?

On the latter point, you have to go all the way back to 1936 to find a US electoral cycle that has a down market in its third year. That year was 1939 – the start of World War Two.

Bill McQuaker and Katy Gladstone are heads of multi-manager investment at Henderson Global Investors

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