Highlights of Recent Trends in Financial Markets

One of the strongest influences on world financial markets in late 2000 and early 2001 was a stream of information about the strength of the macroeconomic situations in individual countries. In particular, firm evidence indicated a sudden slowdown of the US economy (and confidence indicators dropped to their lowest levels for five years), prompting a sequence of cuts in official interest rates. Growth rates in continental Europe, having been buoyant for more than a year, slowed down. This gave rise to discussions about the areas ability to emulate the sustained US macroeconomic upturn and created uncertainty about asset pricing and the future course of monetary policy. Finally, fresh concerns about the health of the Japanese economy triggered renewed bouts of financial market uncertainty. On top of this, recent years enthusiasm about dot.com enterprises, the TMT sector (technology, media and telecom) and all things Internet has evaporated. Since investments in this sector used to be one of the most vibrant financial market activities e.g. in the fields of innovator markets and venture capital the turnabout has contributed to a generally cautious mood among market participants. a) Exchange rates Since the previous issue of this publication, the declining trend in the euro vis--vis the US dollar has been reversed (Figure 1). The euro picked up sharply in December 2000 and briefly reached levels at near-parity with the dollar (at around 0.96) in the first days of 2001 before falling back somewhat. The movements were seen as a vindication of those exchange market analysts who have long attributed
OECD 2001

Financial markets are influenced by growth prospects

and by the down-pricing of tech stock.

The euros downward trend is broken

Financial Market Trends, No. 78, March 2001

Figure 1. Comparative Daily Exchange Rates: relative to US dollar

Japanese yen 102.5 100.0 97.5 95.0 92.5 90.0 87.5 85.0 82.5 80.0 Jan. Feb. Mar. Apr. May June July 2000 Aug. Sept. Oct. Nov. Dec. Jan. Feb. 2001 British pounds Euro 102.5 100.0 97.5 95.0 92.5 90.0 87.5 85.0 82.5 80.0

Source: OECD.

the euro-dollar movements to market expectations to near-term macroeconomic performance. The shifts in bilateral rates since October 2000 cannot easily be explained by parameters such as interest rate differentials, trade imbalances, or even by observed changes in investment flows. They do, however, coincide with the first occurrence of evidence that the US economy was slowing down (in October and November 2000) and with the publication of data in January 2001 indicating that the continental European upturn was less buoyant that initially assumed. amid a weakening yen The Japanese yen which had long remained surprisingly strong, given the weakness of the Japanese economy has declined significantly over the last four months. The explanation offered by market analysts is that the yen was long held within bounds by the opposite forces of domestic macroeconomic fragility and sizeable current account surpluses. The weakened outlook for economic recovery, taken together with the renewed signs of structural problems in the financial
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Highlights of Recent Trends in Financial Markets

sector (see below), appear lately to have pushed the balance toward depreciation of the currency. The pound sterling appears to have become increasingly detached from the US dollar and closer linked with the euro. This development, which is to some degree also reflected in bond prices, started when UK growth rates slowed down earlier than the US ones. Financial markets seem to have concluded that the cyclical position and inflation outlook w o u ld be gi n t o cl o se r m i rr o r d e v e lo p me n ts i n t h e euro-zone. With the US economy now slowing down, the euro-zone economies are moreover the most attractive markets for UK exports. b) Equity price depreciation The past 12 months have witnessed the deflation of what, with the benefit of hindsight, appears to have been a high-tech equity price bubble. In the United States the price of technology shares has been trending downward since March 2000. The technology intense NASDAQ index traded marginally above 2 100 in early March 2001, down from its peak at 5 049 one year earlier. By an alternative measu re, Figu re 2 sho ws h ow US t echn olo gy sh are s ( technology here loosely defined as TMT) declined by at least 40 per cent over the twelve months from February 2000 to February 2001. The decline in TMT share prices depressed general indices especially in the last few months but it is remarkable how overall stock indices in the United States excluding TMT have actually been on a growing trend for several months. EU area technology shares have recorded a decline of a comparable magnitude since March 2000 (Figure 3). In fact, the similarity in pricing corrections across the Atlantic was among the factors that made observers perceive the phenomenon as elements of a pricing bubble. Since Europe has seen much less of a mark up of stock prices especially high-tech stock in the 1990s than the United States, and the medium-term outlook for the EU countries looks healthier, there is no fundamental reason why TMT prices in Europe should drop in unison with the US ones. Some analysts have
OECD 2001

and a pound sterling more in line with Europe.

US tech stock is sharply lower

followed by Europe

Financial Market Trends, No. 78, March 2001

Figure 2. Stock indices: United States

Total 150 140 130 120 110 100 90 80 70 60 Sept. Sept. Feb. Feb. Oct. Aug. Oct. Aug. June June Apr. Apr. Dec. Nov. Nov. Dec. Mar. Mar. Jan. Jan. May May Jan. 2001 250 200 150 100 50 0 Sept. Sept. Feb. Feb. Aug. Aug. Oct. Oct. June June Apr. Apr. Dec. Nov. Nov. Dec. Mar. Mar. Jan. Jan. May May Jan. 2001 July July July July Total except TMT TMT 150 140 130 120 110 100 90 80 70 60

1999 Source: Datastream.

2000

Figure 3. Stock indices: EU

Total 250 Total except TMT TMT

200

150

100

50

10

1999 Source: Datastream.

2000

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Highlights of Recent Trends in Financial Markets

Figure 4. Stock indices: Japan

Total 350 300 250 200 150 100 50 0 Sept. Sept. Feb. Feb. Aug. Aug. Oct. Oct. June June Apr. Apr. Dec. Nov. Nov. Dec. Mar. Mar. Jan. Jan. May May Jan. 2001 July July Total except TMT TMT 350 300 250 200 150 100 50 0

1999 Source: Datastream.

2000

attributed the simultaneous price movements to financial market contagion, but it must also be seen in connection with the fact that institutional investors, especially those based in the United States, have been active in the markets for technology shares in a wide range of countries. Figure 3 shows that apart from the TMT price fluctuation there would have been virtually no change in EU stock indices over the last two years. A similar pattern is seen in Japan (Figure 4), although here the build-up of equity prices in 1999 was also linked to an apparent economic recovery. As a result, the gradual correction in TMT stock prices up to February 2001 did not entirely give back earlier gains. However, recent political, macroeconomic and financial sector disturbances have severely depressed equity prices across economic sectors. On 2 March the Nikkei 225 was trading at 12,162, its lowest level since the mid-1980s.
OECD 2001

while Japanese stock prices suffered more generally.

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Financial Market Trends, No. 78, March 2001

c) Venture capital Weak tech stocks were bad news for the venture capital industry The drop in technology-related equity prices has had a s ig n i fi c an t i mp a ct o n t h e ve n t u r e ca pi t a l i n du s t r y throughout the OECD area. A general weakness of second tier or innovator stock markets have created uncertainty about the feasibility and profitability of future IPOs, thereby sowing doubts about the exit strategies of venture capital investors. In Europe the evidence of this was particularly compelling in Germany, where providers of risk capital publicly voiced concerns about the weakness of the Neuer Markt. In the United States, both inflow of funds to venture capital companies and the investments made reached an all time high in 2000. True, activity slowed in the fourth quarter, but investment still reached a level above 20 billion US-dollars (USD), which is very high by historical standards (Table 1). It may seem counter intuitive that activity has held up so relatively well, but market analysts have observed that inflows to venture capital companies largely reflect the observed returns to venture capital investment in the previous quarters. Since returns in 1999 were the highest in the history of US venture capital (according to the National Venture Capital Association the quarterly return in 1999: Q4 was a staggering 59 per cent), it is not entirely inexplicable that total fundraising rose to a record USD 92 billion in 2000. It does, however, raise concerns about the immediate future of the industry because, by the end of 2000, returns had dropped to around 5 per cent, far below the long-term average of 20 to 25 per cent. For these reasons, most observers predict an important contraction in the inflow of funds in the course of 2001.

which slowed down in 2000: Q4.

Table 1.

US venture capital investment

Number of companies Amount invested (million USD) 7.037 12.726 14.110 25.293 27.224 27.620 28.604 20.400

12

1991: Q1 1999: Q2 1999: Q3 1999: Q4 2000: Q1 2000: Q2 2000: Q3 2000: Q4

875 1 198 1 322 1 610 1 743 1 863 1 794 1 460

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Highlights of Recent Trends in Financial Markets

The most remarkable slowdown in US venture capital activity in the second half of 2000 related to venture-backed mergers and acquisitions (M&As). The total value of such deals (including the share not financed with venture capital) fell to USD 14.9 billion, from USD 52.6 billion in the first half of the year. Now as before, the largest M&A activity was in internet specific companies, which made up for half the total amount. The largest individual deals were the acquisition of Broadband Access Systems by ADC Communications and the acquisition of NewPort Commmunications and Silicon Spice by Broadcom. d) Government bonds Against a background of weakening equity prices and lower short-term interest rates, long-term bonds were among the high-returns investment objects in the beginning of 2001. According to calculations by JP Morgan, government bond holdings in OECD countries generally produced a yield of at least 8 per cent (in national currency) over the last 12 months the only notably outlier being Japan with its unusually low interest rates (Table 2). The trend was confirmed in February. In the dollar bloc, the United States outperformed Canada and Australia. Treasury yields across the curve declined Government bonds performed strongly

especially in the United States

Table 2.

Government bond markets total return (not annualised)

February Year to date 2.22 1.47 1.38 1.31 1.24 1.23 1.38 2.32 1.26 1.35 0.80 0.71 2.01 12 months 13.63 8.58 9.47 8.62 8.35 8.31 7.93 5.20 8.54 8.27 10.30 8.80 14.13

Australia Belgium Canada Denmark France Germany Italy Japan Netherlands Spain Sweden United Kingdom United States Source:

0.73 0.53 0.92 0.64 0.49 0.51 0.44 1.03 0.51 0.49 0.17 0.22 1.27

JP Morgan Government Bond Index Monitor.

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Financial Market Trends, No. 78, March 2001

by 10 to 20 basis points over the month driven mainly by deterioration in consumer confidence and poor equity market performance. At the end of February, market analysts consensus forecast of a further 50 basis points reduction in Federal Fund rates was apparently priced into the market. The month ended with a rally, as equity markets continued to fall and consumer confidence was reported at its lowest level in more than 4 years, thus further heightening the expectation of a monetary policy easing. Euro-zone markets posted a return of 0.45 per cent. Markets in Europe ended higher, but changed direction several times during the month. The ECB left rates unchanged and is widely expected to stay on hold in the near term, as the economic data though perhaps less buoyant that previously expected have been mostly on the strong side. Inflation remained well above the ECB target. The Bank of England cut rates by 25 basis points as a precaution against the US slowdown. This move was widely anticipated, and hence already priced into the market, which ended flat on the month. while some problems remained in Japan. Japanese government bonds yielded 1.03 per cent in February, as the BOJ cut the overnight interbank rate in response to renewed calls for liquidity. Meanwhile, S&P downgraded Japan from AAA to AA+, citing rising debt levels and concern over the Japanese authorities ability to implement structural reform. e) US corporate bonds US corporate bonds were softer The strong returns on US government bonds over the last year occurred as the corollary to a trendwise decline in long-term interest rates. The lower rates were partly triggered by a succession of monetary policy easings that markets h ad pre dicted well in advan ce . Howeve r, othe r long-term interest rates have generally not followed the treasury bonds down, which indicates that additional factors are at play. Spreads between both high-graded and lower-graded corporate bonds and treasuries have continued widening during the past 12 mon ths. The spreads now stand at a historically high level that is even above what was recorded
OECD 2001

at the prospect of an business sector downturn.

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Highlights of Recent Trends in Financial Markets

Figure 5. Yield spreads between US corporate bonds and 10-year treasuries

Aaa Percentage points 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0 Baa Percentage points 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0

July

July

Sept.

Sept.

July

Sept.

Mar.

Mar.

Mar.

May

May

Nov.

Nov.

May

Nov.

Jan.

Jan.

Jan.

1998 Source: Federal Reserve Board.

1999

2000

in the aftermath of the LTCM crisis (Figure 5). One reason for this is undoubtedly a trend difference between the supply of government and corporate bonds. With the US government debt shrinking and the corporate sectors demand for funds remaining strong at the late stages of the economic upturn, an increasing selectivity on the part of investors has gained hold. As for the pricing of corporate bonds per se, investors seem to be displaying an increasing focus on quality. As evidence of a slowdown of the US economy has mounted, investors have become increasingly concerned about the prospect of some companies facing difficulties with servicing their debt. f) Unresolved problems in the Japanese banking sector The continued drop in Japanese equity prices since the temporary peak in February 2000 has begun to raise serious worries among market participants as to the health of financial institutions balance sheets. At the beginning of March, the Nikkei 225 stood at 12100, its lowest level for more than a decade, and a level at which several of the larger banks are
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Stock market weakness

Jan.
2001

15

Financial Market Trends, No. 78, March 2001

estimated to begin encountering problems with negative hidden reserves. Some commentators in Japan vented the possibility of a substantial monetary easing or even direct public interventions in the equity market to sustain prices. continued problems with bad loans In a parallel development, Japanese authorities have announced measures to deal with the continued high levels of non-performing loans (NPLs) in banks. The Financial Supervisory Agency (FSA) announced a framework for cutting bad loans to be made public by end-March 2001 and to be completed before March 2002. Almost at the same time, the Financial System Council recommended opening a market for trading NPLs. If indeed the authorities are to encourage the sale of NPLs at market prices, or otherwise deal with them within the coming 12 months, the result could be further pressure on banks balance sheets. Partly in anticipation of this, the Bank of Japan eased monetary policy in the last days of February, lowering key official interest rates to 0.15 per cent. These moves have been attributed by analysts to an apparent recent worsening of the problems with bad debt. FSA recently announced that banks had 63.9 trillion yen in problem loans on their books as of September 2000, which represented a net increase since March 2000. Those loans accounted for 12 per cent of the total credit extended by the 136 banks surveyed. Meanwhile, the healthy portions of the loan books reportedly kept shrinking. and an uncertain valuation of real estate An additional cause of concern has been doubts about the valuation of real estate assets in the books of financial and non-financial enterprises. The Ministry of Finances survey of private sector balance sheets shows that land currently account for 13 per cent of total assets, compared with 8 per cent in 1990. According to the Real Estate Institutes conservative assessment, the average price of urban land has fallen by 25 per cent during the same period, which has led analysts to suspect that many enterprises are, still, weighed down by undisclosed losses on commercial property. On top of this, even in their ongoing core business Japanese banks remain considerably less profitable than their counterparts in other major economies. The pre-provisioning profits of the four mega-banks that will emerge from current mergers (discussed in some detail in an article in Financial
OECD 2001

all add to the structural problems in the banking sector.

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Highlights of Recent Trends in Financial Markets

Figure 6. Pre-provision profit as share of risk-weighted assets

Large Canadian Banks Large Australian Banks Large United States Banks Large United Kingdom Banks

Fuji/DKB/IBJ Asahi Sanwa/Tokai BoT Mitsubishi Sumitomo/Sakura 0 0.5 1.0 1.5 2.0 2.5 3.0

Source:

Moodys.

Market Trends, Vol. 77) are estimated at 70 to 90 basis points relative to risk-weighted assets (Figure 6). By contrast, in most English-speaking countries this ratio ranges from 200 to 300 basis points. Cost efficiency, measured by operating expenses as a share of operating revenue, was similar in Japan and in comparable countries. Thus, one can tentatively attribute the poor earnings to performance to low earnings margins rather than high expenses Banks continue to concentrate on low-return business, especially on-balance sheet lending to large corporations. Fee-incomes from off-balance sheet activities account for a relatively low share of earnings. In addition, the Japanese banks have been slow to raise lending margins to reflect credit risk, partly due to the low interest rate environment and partly because many companies are only marginally able to service their debt and may not be able to withstand market-priced lending margins. Competition, on both the lending and borrowing side, from public entities such as the Housing Loan Corporation and the Postal Savings System
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Financial Market Trends, No. 78, March 2001

puts pressure on margins in retail banking. Market analysts expect results for the fiscal year ending in March 2001 to show declines in net operating profits offset by profits from equity sales and lower costs g) Financial turmoil in Turkey An exchange rate crisis in Turkey In the last week of February, Turkey was rattled by a foreign exchange crisis that could augur serious problems for the national banking system. In late 2000 a previous financial crisis, partly triggered by the burst of a stock market bubble, had to be staved off through a massive injection of funds by international lenders. This rescue package was designed to bolster confidence in Turkeys currency peg while giving the government the time to engage in the appropriate structural reform programmes. However, as evidenced by the fact that asset prices continued sliding in January and February, investors confidence failed to recover. On 21 February, the central bank lost 25 per cent of its foreign currency reserves and overnight interest rates were hiked to more than 4000 per cent. On 22 February, the government announced that it would allow the Lira to float, which, following a degree of initial overshooting, seems to have stabilised at a around 25 per cent below its pre-crisis level. Analysts generally agree that the Turkish banking system both contributed to the gravity of the crisis and was one its principal victims. A particular problem relates to the state-owned banks, which, in addition to being frequently criticised for their apparently opaque governance, have been burdened with having to lend into government-mandated subsidy and preferential credit programmes. These banks, which account for some 40 per cent of all bank assets, are estimated to have run up non-performing loans to the tune of 13 per cent of their total loan books already before the crisis (Table 3). occurred in connection with a weak domestic banking system
18

The privately owned banks apparently engaged in the high-risk strategy of funding themselves on (low interest rate) short-term liabilities denominated in foreign currency, while investing in higher-yielding domestically denominated securities. Bank balance sheets from September 2000 show that 61 per cent of the privately owned banks liabilities were denominated in foreign currency compared with 45 per
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Highlights of Recent Trends in Financial Markets

Table 3. Non-performing loans of Turkish banks (as percentage share of total loans)
September 1999 Commercial banks State-owned Privately-owned Banks in Fund Foreign banks Development and investment banks Total Source: Turkish Banking Association. 9.3 11.4 3.3 238.8 2.9 2.5 8.7 December 1999 11.7 10.0 3.6 162.8 2.7 2.0 10.7 September 2000 10.0 12.7 2.9 185.1 3.2 2.1 9.3

cent of the assets. Market participants expect this discrepancy to have grown significantly during the crisis. For example, Turkish private sector borrowers secured international credits of USD 4.4 billion in the fourth quarter of 2000, up from USD 2.6 billion in the third quarter. The combination of a currency and a maturity mismatch between assets and liabilities makes the banks highly vulnerable to the current environment of weak exchange rates and continued high money market interest rates.

19 OECD 2001