Global Markets Weekly – 19^th March 2007

Key Macro economic developments

• There was only one game in town last week as far as investors were concerned - the growing difficulties within the sub-prime mortgage market in the United States, and the possible implications for both financial market stability and the real economy. Signs of stress within sub-prime lending have been brewing for sometime. A number of the smaller lenders specialising in this market had reported difficulties in meeting liabilities, or simply closed entirely, leading to a series of ‘paper’ losses for the larger financial institutions that have assumed some exposure to sub-prime in recent years. But last week’s news of a sharp rise in delinquency (payment arrears) rates on sub-prime mortgages during the final quarter of last year seemed to bring the matter to the forefront of investors’ minds, prompting a further bout of risk aversion and volatility.
• The sub-prime component of the US mortgage market – effectively lending to those with impaired credit histories and/or low incomes – has grown rapidly in recent years. On a flow basis, sub-prime may have accounted for a quarter of mortgage origination last year, up substantially from the close to 5% share just a few years earlier. But the stock of sub-prime mortgages is still thought to account for less than 10% of outstanding loans, and the significance of the sector falls still further when the typical consideration of the loans in question is considered. On a narrow viewpoint, therefore, the bulk of the US mortgage market – where delinquency rates have been effectively stable – should be relatively unaffected by what in some respects is still a localised, specific issue. Indeed, the very structure of the US mortgage market, which has been shaped by successive bouts of government intervention and is subsequently dominated by government-sponsored enterprises, is designed to ensure the steady supply of housing finance during periods of financial stress.
• But on a broader basis, the fact that an increase in delinquency rates has occurred outside of a substantial slowdown in growth, with the US economy still operating close to most estimates of full employment, will be of concern for investors during the current climate of risk aversion. The sustained period of house price inflation and growing affordability issues look to have given rise to aggressive lending practices, and the growing popularity of non-conventional mortgage products has not been entirely confined to the sub-prime area. These ‘affordable’ products – the most common form of which is the adjustable rate mortgage - offer initially lower borrowing costs but expose households to interest rate risk as the discount periods end. The expiration of these ‘lock-in’ periods could therefore prove to be a drag upon the US housing market, and consumer spending in general, for some time to come. In addition, with lending standards now likely to tighten significantly as providers seek to avert any further losses, the ability of households (particularly in the sub-prime sector) to re-mortgage off such products will now be more limited.
• Overall therefore, while last week’s events may essentially relate to a small sub-section of US mortgages, the factors driving these difficulties could yet prove to be of wider significance. As such, investors are unlikely to break what is now a long-running focus upon developments within the US housing market anytime soon, even if the continued strength of the US labour market and robust corporate sector still argue against a substantial slowdown in growth.

Key global market developments

• The concerns over US sub-prime lending ensured that equities remained on the back foot last week, but if the experience of the other mid-cycle corrections of the recent past is any guide, some stabilisation could now be close. Since the current rally in equities began in March 2003, several corrections have occurred and a similar pattern can be observed; equities tend to lose around 6% from their earlier peak over a period of roughly seven weeks, before a steady, more gentle recovery ensues. The current downturn appears to be roughly conforming to this trend, and matching the pattern of last May’s correction particularly closely, suggesting that a stabilisation could now be close if this usual relationship holds.

Indices, Interest rates and Inflation

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