Investors can only factor in the short term

IN late January US Shale Solutions, an oilfield services company, announced it was restructuring a debt issue. This involved a 57 per cent haircut on the debt and new terms to allow it to pay creditors interest in securities rather than cash, as the number of distressed and defaulting high yield energy companies continues to rise. Some managers say the combination of stress in this corner of the credit market and potential illiquidity spell eventual disaster - first for credit markets in the US and, thereafter, for everyone else.

At the same time, major banks around the world are receiving word from Saudi fund managers to liquidate all their managed accounts. One fund manager with exposures in Japan worries that much of the selling pressure on Japanese shares comes from Riyadh, as weak oil prices wreak havoc on Saudi budgets.

Meanwhile, stocks rose in the US the past week as oil prices moved higher, supported by rumours that Opec may focus on prices rather than market share. Indeed, in recent days, the US stock market has become far more fixated on oil than on discrete whispers of more easing measures from Europe and Japan.

Capital markets are once again emitting conflicting signals. Some of those signals have to do with timing and the fear of many shorts that there may be a brief rally on the combina- tion of another possible bout of easing - or delayed tightening in the case of the Fed - and signs of stabilisation in the energy markets. That helped spreads, or risk premiums, narrow in the high yield market last week.

But the underlying fundamentals remain gloomy. For one thing, the overall drop in oil prices is a demand-side phenomenon as well as a question of supply. Less robust, less energy-intensive growth is a secular phenomenon, despite the fact that some consumers are buying large vehicles.

Moreover, there is a concern that central banks may be losing their efficacy. Their lack of action can lead markets down, while their ability to lift financial asset prices shows signs of having less traction than in the past as central banks resort to ever more extraordinary measures.

A surprise shift by the Bank of Japan to adopt negative interest rates for some reserves on January 29 sparked a rally in the share market and a weaker yen. That said, leading share markets in Japan ended January lower by nearly 8 per cent. While markets may enjoy a short-term boost, it remains to be seen whether negative rates in Japan and the Eurozone can ultimately spur higher inflation and push up asset prices.

Meanwhile, China will also influ- ence the prospects of many companies on both sides of the Pacific. The combination of the distress in energy and the potential lack of liquidity in credit market products, whether traditional funds or exchange traded funds, continues to be worrisome - if not today then tomorrow. That may not be immediately apparent, though. When asset manager Third Avenue imposed restrictions on investors who wished to withdraw money from one of its credit funds earlier this winter, the market shrugged off the initial shock as an outlier.

There was no immediate contagion. Third Avenue was easy to dismiss precisely because many of the holdings were absurdly illiquid and never should have been held by a fund that promises its investors to return their money in a short period of time in the first place.

Still, it is possible to argue that there are often tremors in markets that only in retrospect turn out to have been clear warning signs. In July of 2007, for example, when two Bear Stearns hedge funds with large subprime holdings collapsed, or the following month when BNP announced it was unable to value holdings of subprime securities, the dimensions of the financial crisis stemming from such securities wasn't yet apparent for many more months. Moreover, many investors, including big buyout firms, have safeguarded their energy investments with hedges on oil prices. Those hedges will start expiring soon, which will force writedowns both for investors and banks.