2008: Global Markets Review

What a difference a year makes. At the start of 2008, many market analysts were predicting that global share prices would rise this year, exceeding the record highs seen towards the end of 2007. Instead, we have seen a catastrophic collapse in global equity market value. The FTSE All-World Index, measuring developed and emerging economies, began the year at $34 trillion and proceeded to lose some $17 trillion in wealth.

January began with investor jitters over monoline bond insurance companies (like MBIA and Ambac) who were facing ratings cuts. These small companies guarantee the repayment of bond principal and stood behind many of the credit instruments (like collateralized debt obligations) that were already showing signs of distress. Many forecasters claimed that the monolines would need a significant injection of cash to fend off a collapse.

On January 22, in an attempt to stem global pessimism, the Federal Open Market Committee in the US cut its target federal funds rate by 75 basis points. The dramatic move was largely unanticipated and gave stocks a considerable bounce following the Davos summit in Switzerland. Two days later, officials at the French investment bank Société Générale announced that one of their rogue futures traders had single-handedly lost $7.2b. The news reassured some traders who thought the story might explain the rapid sell-off in January.

The ensuing rally proved to be unconvincing, however, as the dollar lost ground, China and India saw their economies slowing, and the price of oil began its record ascent. By March, another crisis loomed as Bear Stearns, facing insolvency, was forced into a merger with JPMorgan Chase with money supplied by the Fed. Analysts were already concerned about Lehman Brothers, but the financial rescue of Bear led many to believe that policymakers would not allow a major investment bank to fail.

Markets recovered on this sentiment, and rising commodity prices brought on a new fear: inflation. In June, the Fed threatened to raise interest rates, and the European Central Bank (ECB) actually hiked rates 25 basis points in July. These policy measures, mixed with lingering fears in the credit market, quickly snuffed out the year's stock market rally.

The end of the summer brought on a dizzying crisis in the financial markets. Gloomy economic data and credit fears created a toxic mix that led to a giant sell-off of Fannie Mae and Freddie Mac. As their share prices fell, it became more and more difficult for these mortgage institutions to raise capital, which in turn put greater downward pressure on their stock. In July, this negative cycle ultimately forced the US government to announce it would backstop Fannie and Freddie's debt.

The brief inflation scare was now a full-blown recession panic. Trading volumes thinned, hedge funds began to worry about redemptions, and investor confidence was shaky. On September 7, the government nationalized Fannie and Freddie, which sent signals to the market of a worsening crisis. On September 14, Lehman Brothers filed for bankruptcy after the government's reckless experiment with free-market principles. Many observers now point to this moment as the inflection point of an accelerating downturn.

Soon thereafter the huge insurance company AIG asked for a bailout, Merrill Lynch was sold to Bank of America, and Washington Mutual (the 6th largest bank in the US) failed and was ultimately seized by JPMorgan Chase. News of the government's $700b rescue package briefly lifted stocks, only to be voted down by the House of Representatives on September 29. To make matters worse, European banks were discovered to be more leveraged than their counterparts in America, Iceland's banking system collapsed, and traders the world over couldn't get their money out of Lehman's bankruptcy proceedings.

The tumult of September led to Black October. Curiously, the slew of government rescue packages actually invited speculation against the world economy. The week after Congress passed the Troubled Assets Relief Program (TARP), US stocks suffered their worst 5-day performance since the 1930s. Huge losses forced world governments to pursue more extreme actions. The UK began purchasing direct stakes in its banks to help recapitalization and an array of central governments agreed to a coördinated rate cut.

More aggressive monetary policy had the desired effect, but the rally was short lived. When Treasury Secretary Henry Paulson announced that the US would follow Britain's plan to buy shares in banks (and not purchase distressed mortgage assets) there was widespread panic around Citigroup, which has heavy exposure to mortgage backed securities. Tumbling share prices forced the government to reconsider, and on November 24 it organized the largest bailout in history for Citi. As the crisis wore on, it seemed the policy responses (especially in the United States) were increasingly myopic an ad hoc.

The next shoe to drop was the burst of the foreign exchange bubble. As investors pulled out of risky investments in emerging markets, foreign currencies collapsed and borrowers raced to repay their debts. Forex speculators who were playing the carry trade (borrowing in low-interest currencies to invest in higher yielding ones) were forced to rapidly unwind their positions. The instability in the currency market raised the spectre of a sovereign default in emerging markets. For all those who once believed in "decoupling," 2008 was providing a flawless rebuttal.

As the year ends, there is still great uncertainty regarding the credit markets and the direction of equities in the near term. Many analysts agree that markets will eventually recover, but there are still disagreements over whether a bottom has been printed. Even as lending rate indices return to normal (Libor, Euribor, Tibor were all down in the last week) there is still significant fear in the markets. Treasury yields across the board are trading near historic lows with risk management at a premium.

These problems certainly won't evaporate as the calendar turns to 2009, but there are many traders at least looking for a fresh start.