As the third quarter of 2007 draws to a close Friday, it’s important for investors to consider what didn’t happen as well as what did.
BlackBerries and other personal communication devices hummed this summer, as financial traders and other professional investors paused in their vacations to keep up with a severe bout of market stress.
The vocabulary of the financial press was dominated with words such as turmoil, crunch, fear, safe haven and debacle.
Imposition of higher interest rates by central banks in response to robust economic growth tripped vulnerable borrowers, especially U.S. home buyers with less than stellar credit records.
Problems with a small segment of the U.S. mortgage industry quickly spread around the globe, just as securities created from mortgage loans have blanketed the world in recent years.
Suddenly, when mortgage borrowers in the U.S. have trouble paying, “it’s major news in Brisbane and Beijing and Berlin and every town and village in between,” Philip Lowe, assistant governor of the Reserve Bank of Australia, told a conference on global finance Thursday at the Federal Reserve Bank of Chicago.
The snapshot of the summer of 2007, as far as investing is concerned, is the sudden and steep increase in the gap between yields on supersafe U.S. Treasury securities and other debt instruments.
The graphic below, for example, shows the rapid rise in the so-called yield spread between highly rated 10-year industrial bonds and 10-year Treasury notes. Even financially sound businesses with no direct link to the housing industry had trouble borrowing in credit markets.
The yield gap reflects fear among buyers of debt securities that they do not know where the next default will arise. Tension in credit markets is by no means over.
Looking at what didn’t happen, two non-events deserve mention. U.S. stocks did not collapse. The benchmark Standard & Poor’s 500 index, which hit a record high in mid-July, briefly touched a 10 percent decline a month later. But as the quarter ends, the index is ahead a healthy 8 percent for the year.
The price-earnings ratio of the S&P 500 index is unchanged since Jan. 1, indicating no fire sale of equities.
Investor appetite for risk remains strong, especially in international investing. Emerging-market stocks have boomed this year. The iShares MSCI Emerging Markets fund is up 30 percent.
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The other thing that didn’t happen was the failure of a major multinational bank. The prospect of just such a disaster loomed, as global banks faced the consequences of their enchantment with hedge funds and financial engineering. But it didn’t happen.
That’s good, because no one knows how to contain the damage from an international bank crisis or even who would take charge of the job.
“It’s hard to have reform before the crisis,” said Lowe. “Inevitably, we will be forced to face the issue after we have a cross-border bank fail.”
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