The Subprime Solution: Containing Global Contagion

The issue du jour is the subprime space in the US mortgage market, and whether the problems there will or will not instigate a broader credit crunch, hamper US consumption, and through the yen carry trade and other derivative linkages, instigate contagion in global financial markets. If the problems in the US subprime space cannot be contained and does lead global contagion (i.e., further sell-offs), there will be no place to hide, as equities, currencies and commodities could fall much further.

But we believe that problems in the subprime space can be contained. If the CDO problem does appear to be getting out of hand, the Fed will undoubtedly move to ease in order to avert a recession, which would alleviate a lot of the current pressure in the US housing market.

Thus while the US subprime debacle is certainly not over and there will inevitably be further fall-out, there is no reason to become overly bearish about US, Japanese or emerging market equities. While past examples include the US S&L Crisis in the early 1980s and the Jusen (housing loan) Crisis in Japan in the late 1980s that led to the 10-year “Heisei Malaise”, these were caused and exacerbated by a sharp tightening of monetary policy and a failure to quickly address the problem.

How this plays out for Japanese stocks is that foreign investors have been selling on yen strength, with the financials (megabanks, brokers and insurance companies) leading the downside until the smoke of the US subprime debacle clears.

On the other hand, the market-leading rallies in the real estate, services, shipbuilding, steel and shipping sectors have only temporarily been interrupted. Moreover, investors continue to pick and choose among domestic-oriented high yield/high value stocks. This includes REIT stocks.

Indeed, the global sell-off has not noticeably slowed the pace of large holding filings by foreign investors, even though foreign investors have been net sellers for the past several weeks.

Comments

[ken]

Tough issue. For one, I expect the Fed to be proactive rather than reactive here. The housing bubble has not burst in the dramatic fashion that, for example, the Economist was saying it would a year ago. As far as effect on the carry trade goes, I can't see much just yet - Japan's overnight call rate is still 0.5% and doesn't look to go anywhere above that until after upper house elections this summer, due to political pressure. That might not be as appealing as the 0% rate last February or the 0.25% rate two months ago, but it's still low enough, and should last long enough, to make some aspects of the carry trade still appealing to the non-risk averse. Japanese equities still look very appealing from Stateside, from what I'm hearing, though I wonder about some of the picks I often hear of...

[Darrel Whiten]

Dear Ken;

Remember Y2K and all of the "smart guys" telling us how this would bring down the civilized world? The Fed and other central banks reacted by providing massive amounts of liquidity to ensure the "doomsday" scenario would not come to pass...what a great stimulous for global stock markets!

The Japanese political scene makes for greate media coverage and speculaton among foreign investors, but has precious little to do with what goes on in the realy economy--and therefore only has a passing impact on the stock market. This is because politics in Japan is largely irrelavent to
what is actually going on in the real economy! For a reality check, all you have to do is track what Japanese politicians actually do versus what they say. At the end of the day, political action in Japan inevitably gravitates toward what is considered the best solution for Japanese business and the financial markets, i.e., a very investor -friendly compromise...