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Irrational thinking

The term “irrational complacency” was coined by a New York Times columnist in the run up to the summer’s credit market turmoil.

It was an apt expression. With risk premiums diminishing gradually over the last few years, many asset classes were seemingly pricing in the best of all possible worlds. However, reality suddenly intruded when default rates started to rise in the US and the billions of dollars worth of credit derivatives that had been written against these loans turned sour. The process of returning to some sort of normality has been painful for many, especially geared investors in credit markets.

As with other crises, the consequences were strange and unpredictable. When Russia defaulted on its sovereign debt in 1998, the resulting flight to quality prompted a number of highly geared trades by hedge fund Long Term Capital Management to turn sour, prompting one of the biggest financial bailouts in history. Similarly, the sub-prime mortgage debacle has resulted in normally highly liquid commercial paper markets drying up. Such has been the mutual suspicion between financial institutions that money market funds – considered to be near cash – have been forced to close their doors temporarily while the yield on one-month US treasury bills slumped to 2.33 per cent against a Fed funds target rate of 5.25 per cent.

This highlights just how much greed and fear drive markets in the short term. Never has Warren Buffett’s view been truer, that, in the short term, markets are a voting machine while in the long term they are a weighing machine. Market sentiment can turn on a sixpence but the fundamentals should hold true in the long run. Our view is that investors should focus on the fundamentals which we do not believe have changed substantially.

It is far from clear what the implications of a tighter credit market are for the real economy. One would certainly assume some repercussions for economic growth, particularly in the US if consumer activity continues to slow. Central bankers are therefore likely to start relaxing monetary policy at the first sign of any weakness.

Fundamentally, we still think equities offer good long-term value after the sell-off, given the overall health of company profitability, global economic growth and modest valuations. Further volatility is quite likely until nervousness in credit markets settles down, however. It is easy to forget that equities are inherently volatile when markets have been making such good progress, as they have over the past four years. Volatility aside, though, we still favour equities for the long term.

John Chatfeild-Roberts is head of the independent funds team at Jupiter


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