David Joy: Cyprus and Investor Psychology

With a deal apparently having been reached in Cyprus, investors can hopefully turn their focus to economic and market fundamentals. Not that there was ever excessive concern that the problems of the Cypriot banking system would evolve into a contagion that would spread elsewhere in the Eurozone, and perhaps beyond. The market reaction was more akin to a wait-and-see approach, as stock prices mostly just paused during this episode and credit markets showed few signs of stress. There was some evidence of safe-haven buying in Treasuries, gold and in the dollar, but nothing excessive. Most likely this was due to widespread expectation that a deal would ultimately be reached. Or, in its absence, that a systemic failure in Cyprus would not be of sufficient size to impact global economies, never mind the rest of the Eurozone. Or perhaps it was because we have become inured to the succession of crises that have emanated from the Eurozone and elsewhere in the past three years, only to be resolved or papered over at the last minute.

But even if this latest crisis has been contained, there can be no denying the fact that investors have been handed one more thing to erode their confidence, even in a small or subconscious way. The cumulative effect of these events has to have taken a toll. You can be sure that, even though the U.S. banking system is sound, and never in any danger from events in Cyprus, depositors will now be paying attention to FDIC insurance, perhaps for the first time. Depositors throughout Europe are certainly doing so.

And it remains an open question as to whether there will be a lingering impact on investor and consumer psychology from the broader financial crisis, just as there was for the generation that lived through the Great Depression, even accounting for the difference in the severity of the two events. For example, much has been made of the extent to which consumers have repaired their balance sheets. But absolute debt levels remain high by historical standards. What are the implications for the economy if consumers continue to deleverage, if their attitudes toward debt have permanently changed? Much has also been made of the rebound in housing. But what if the promise, appropriate or not, that home ownership historically afforded of not only shelter but a good investment as well, has been broken? The rebound in housing is welcome. It is contributing to economic growth instead of subtracting from it. But that rebound remains at historically low levels of activity. And in certain markets it is being driven by investors, not long-term owners. And while lending is improving, banks are not exactly anxious to write new mortgages. What if the psychology of home ownership, and mortgage debt, has changed? How far will the rebound in housing run in those circumstances? It may turn out that the scars of the financial crisis will fade over time, and a relatively short time at that. But that is not a certainty. And only time will tell.



Interestingly, there are those who are looking at investment markets and warning of the opposite effect. They are concerned that signs of excessive risk-taking are already evident in certain segments of the bond market, for example. New Fed Governor Jeremy Stein has voiced his concern that below-investment grade bond and leveraged loan markets spreads have become too tight and investor protections are being eroded in the structure of new issues. Of course, he is right to raise warning flags concerning the risks associated with the Fed's own policies that are pushing investors further out on the risk spectrum in an effort to find yield. But so far, deal structures have not experienced significant deterioration and available yields seem appropriate, given benchmark levels and strong balance sheets. The point is that the Fed's policies come at a price, and we must be on guard against unintended outcomes.

Maybe investors will increasingly differentiate between how they view financial investments and how they view other types of assets, particularly those purchased with debt. It is one thing to assume risk; it is another to assume risk that is financed with a liability. If so, in the long run balance sheets will be stronger, and the financial system will be less leveraged. In the short run, it may mean slower potential growth for the economy.

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