Signs of 'panic and capitulation' amidst the market carnage

Paul Niven, Head of Asset Allocation at F&C Investments, comments on the current market turmoil: "The deterioration in the US and global economic backdrop has intensified over recent weeks and market volatility has continued to be led by turbulence emanating from the credit markets, culminating last week in the collapse of Bear Stearns.

The extent and depth of the downturn in credit markets, right down to a freezing up of the short dated Asset Backed Securities (ABS) market, has led to fears that the financial system is in danger of ceasing to function properly. The risks which have become all too evident in recent days were largely underestimated by most investors until last weeks' news that one of the largest Banks in the US, Bear Stearns, faced insolvency and was to be bought by JP Morgan.

The collapse of Bear Stearns has sent shock waves through the financial markets, and caused the Federal Reserve Chairman, Ben Bernanke, to take swift action once again. The Federal Reserve has since lowered the discount window, agreed to accept Asset Backed Securities as collateral, and continued to inject liquidity into the financial system to prevent a systemic crisis, in addition to effectively underwriting the purchase of the failing bank.

Risk assets have, unsurprisingly, been under strain given the concerning fundamental backdrop and ongoing credit crisis. This has led to equity markets reaching new lows in March. The aggressive measures being undertaken by the Federal Reserve, have only, however, provided a very short term support for equity markets, with the sell off resuming after the Bear Stearns news. Markets are again looking to test new lows.

The S& P 500 is on the edge of testing the 'bear' market territory of a 20% fall, having now fallen nearly 19% from its September 2007 peak. The reaction in credit markets has been even more severe as the Credit Default Swap (CDS) market continues to sell off with the iTraxx crossover rising above 600 basis points. Unsurprisingly the extreme wave of risk aversion in markets has been accompanied by a flight to safety, with two year US treasury yields now below 1.5%, and gold prices reaching new all time highs.

Going forward, the backdrop for financial markets can be characterised as fragile both from a medium term, but particularly from a short term, perspective.

The medium term outlook has become increasingly clouded by the fact that the US economic slowdown has become broad based, with little signs of stabilisation, and that earnings downgrades are expected throughout the year.

The short term strains on the financial system and the potential impact of further major institutions coming under pressure due to the crisis in the credit markets, add further uncertainty and risk to the coming month. In addition to this, whilst we take comfort from the proactive policy response being undertaken by the Federal Reserve, investors need to see evidence of its effectiveness to avoid speculation that the US is falling into a Japanese style liquidity trap. This all leads towards heightened levels of volatility remaining in financial markets over the coming quarters.

While the US Fed has, arguably, been trying to get 'ahead of the curve' with proactive and aggressive action, with a further 75-100bp likely to be delivered later today, the European Central Bank and Bank of England, have been dragging their heels and focusing on domestic inflationary concerns. This is concerning as we believe that these central banks will, ultimately, have to deliver supportive action to prevent a material knock-on impact on their domestic economies. In addition, it is likely that, as with the Savings and Loan crisis, direct government action (a bailout) will be required before a sustained stabilisation, and subsequent recovery, in credit assets is achieved.

Despite the overwhelmingly bearish news flow, there are some signs for optimism.

Given the market falls we have already seen, we are well over 75% of the way through 'normal' recession bear markets, risk appetite measures now show equity investors are in 'panic' territory, and valuations are becoming increasingly compelling, with many markets relative valuation metrics entering the most attractive levels since the start of the recent bull market.

In addition to equity markets pricing in a lot of bad news, the credit markets are now discounting default rates normally associated with recessions, and the fact that two year US treasury yields are so low indicates recession is already expected and priced in.

Markets will be volatile, but the re-pricing we have already seen leads us towards expecting a moderate rebound in equity markets over coming months. From this perspective, we would caution against panic and capitulation as such sentiment is already evident from the majority of market participants, and instead take degree of comfort that a variety of asset classes are already discounting a bearish outcome, with certain markets (such as equities) arguably already entering into the panic territory usually associated with a rebound in prices. Whilst one needs to exercise caution with risky asset weightings due to the cyclical slowdown we expect, there are several factors leading towards us taking a cautiously optimistic position."