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Crunch time

Over recent times, the financial news has been dominated by headlines concerning credit problems, specifically those associated with sub-prime lending.

This has been going on for much of the year but concerns have intensified in recent weeks. With the uncertainty surrounding the markets, we thought we would offer some perspective on what has been happening and what investors may expect.

Following last week’s equity market declines in the US and around the world – US stocks experienced their worst week since September 2002 – stocks have continued to trade in a choppy fashion. Stocks around the world sold off on July 31 and August 1, with many Asian markets losing between 2 per cent and 3 per cent and European stocks, at the time of writing, also down. US stocks may be in for some rough trading.

These declines are enough to cause investors concern but it is important to keep this correction in perspective. Stocks have been enjoying a bull market since October 2002 and in the past year US stocks are up by 25 per cent. What so far has been roughly a 5 per cent correction is best described as a “bull correction”, a normal consolidation within a bull market.

The main catalyst for market declines has been the July credit crunch. Sub-prime mortgages have been in a meltdown for several months and low-credit investments, including some hedge funds, have experienced a spillover effect. In the last week, there have been some high-profile credit collapses and many investors have been concerned that credit contagion could have a wider impact on the broader economy and other financial assets.

As a result of this, we have seen drying up of the credit availability that has helped drive high levels of M&A and other corporate deal activity. In fixed-income markets, higher-quality bonds, specifically Treasury bonds, have gone up in price and yields have fallen as investors move to relatively safe assets. Bonds associated with housing and credit markets, such as asset-backed securities and commercial mortgage-backed securities, have seen huge price declines.

Finally, expectations for Federal Reserve interest rate cuts have changed radically. On June 30, the Fed funds futures curve was pricing in a nearly 0 per cent chance that the Fed would cut rates in 2007. That moved up to 30 per cent on July 20 and has since spiked to nearly 100 per cent today.

Bob Doll is vice-chairman and global chief investment officer of equities at BlackRock

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