Is The Sub-Prime Crisis Really Over?

Source : The Business Times, Jun 30, 2008

ONE of the most striking things about the past couple of months is how quickly the phrases 'sub-prime crisis' and 'credit crunch' have disappeared from mainstream consciousness, both replaced by 'inflationary worries' and 'oil crisis' as the stock market's main bogeymen.

In its 'Third Quarter Strategy Outlook' dated June 27 for instance, BCA Research said the outlook will be greatly influenced by how oil prices behave: 'The sustained advance in oil is choking off growth in the G-7 universe and could send equities to new lows. A reprieve in the oil crisis is needed for global equities to regain traction but there is no guarantee that such a reprieve will come anytime soon.'

As a result, the research outfit recommended going defensive and that 'portfolio managers should further reduce their equity weightings below benchmark'.

There was virtually no discussion as to whether there could be more sub-prime shocks to come or whether the financial system has really recovered from the huge losses caused by a still-collapsing US housing market.

Similarly, most other outlook reports and stock market updates have assumed that the Bear Stearns bailout and the Fed's actions in March/April have been sufficient to ensure that the sub-prime crisis is a thing of the past.

Readers would do well to ask themselves this question: how likely is it that a credit bubble that was about six years in the making (when the US Federal Reserve started an aggressive rate cutting campaign after the Internet bubble burst) can be so quickly and gently deflated in the space of two to three months?

Although most of the headlines over the past few weeks have focused on oil's relentless climb and the inflationary-cum-growth implications, it is the complacency surrounding the sub-prime crisis that could well be the main problem equities will face over the next few months.

In fact, Wall Street may well be now waking up to this possibility - Bloomberg on Friday reported that it was sharp drops in financial stocks AIG and Merrill Lynch that dragged the S&P 500 to its five-year low and that the reason for the selling was mounting realisation that there are more sub-prime losses to come.

Bloomberg also reported that Lehman Brothers analyst Roger Freeman increased his second-quarter loss estimate for Merrill on expectations that sub-prime-related writedowns will be more than twice as big as previously projected.

The concerns over oil, inflation and growth are of course justified. BCA's 'Emerging Markets Strategy' dated June 27 said these economies will witness a period of slower growth in the months ahead as inflationary pressures rise.

Although a major slump is unlikely, BCA said near-term risks are high and recommended investors 'stay on the sidelines'.

Interestingly, US newspaper Barron's June 23 issue reports (in the 'Up & Down Wall St' column) that fund manager Dewey Kessler from SDK Capital believes that the sub-prime crisis is now moving into its second phase, a phase that will see emerging markets transformed into 'submerging markets'.

The process is said to have only just begun, starting with China, which although it is 50 per cent off its all-time highs, has still a long way to go.

Here, investors may derive some consolation from the relative resilience the Straits Times Index displayed last week, largely thanks to strong support for the banks (OCBC and UOB actually rose over the five days while DBS only lost 2 cents).

However, it is possible that this support came via window-dressing activities ahead of the end of the first half and if so, the start of the second half could see this support withdrawn.

Moreover, US financial stocks are now being sold off as the realisation grows that the sub-prime credit crunch has not yet run its course. If the same realisation and selling spreads to the local banks, the STI will not be able to display the resilience it did last week.

All told, it looks like the worst is still not over yet. Forecasts earlier this year that the second half will be better than the first may well have to be revised.