Another hike by ECB would be quite bizarre
Since that move the markets have become somewhat more relaxed, happier in the knowledge that the US central bank is standing by prepared to do whatever is necessary to rescue the US financial system.
Despite the more relaxed behaviour of the markets this week, it is still early to call the all clear, but with the most important central banker in the world prepared to do whatever is necessary, it is possible to be somewhat more confident about the future.
However, the fact remains that the problems associated with the US sub-prime mortgage market are still impossible to quantify in monetary terms. There is a clear and present danger that further heavy losses might be revealed over the coming weeks and even institutions with nothing whatsoever to do with the sub-prime market could be affected indirectly by financial exposure to institutions that have suffered heavy losses.
The other big issue for the financial system right now is the loss of confidence within the system. Banks are now fearful of lending money on the interbank markets to other banks. Consequently, liquidity in the banking system has dried up to some extent. Were this situation to continue, it would mean that borrowers would find it more difficult to access credit, and might only be able to do so at higher rates of interest.
This sort of credit squeeze would represent the main mechanism through which the financial crisis of recent weeks could translate itself into real economic effects. This is why central bankers in Europe and the US are supplying extra liquidity to the market. To date these actions are proving successful, but the central bankers themselves are making it very clear that they are still very much on high alert.
A couple of months back I was as confident that the ECB would deliver another 0.25% increase in interest rates in September, with the possibility of another around the turn of the year. The market view has changed significantly over the past couple of weeks and most observers now believe that it would be very difficult for the ECB to increase rates in the midst of such a crisis and in an environment where the Federal Reserve is actually cutting rates.
Amazingly however, the ECB this week continued to suggest that a rate increase at the September meeting remains a real possibility. This attitude is difficult to fathom and one would have to say that a rate increase next month would be quite bizarre. However, the anti-inflation dinosaurs in Frankfurt are not averse to the odd bit of bizarre behaviour.
For investors in equity markets there would now appear to be considerable long-term value out there. The fundamentals are still pretty good everywhere from an economic and corporate earnings viewpoint. Those who suggest that equity markets had gone too far and were an accident waiting to happen are not backed up by the facts. The subprime market on the other hand was an accident waiting to happen, but very few people acted in time. This problem will have to run itself through the system before real confidence can be restored and meanwhile volatility and nervousness could be the order of the day for a few more weeks.
However, it is worth remembering that on a valuation basis markets do not look expensive provided you believe that the US economy is not going into recession. This appears to be a well-founded belief.
