Markets spell out challenge ahead

By Michael Mackenzie in New York

Published: January 20 2009 22:22 | Last updated: January 21 2009 02:31

Wall Street marked the first day of Barack Obama’s presidency with the largest inauguration day decline as financial stocks hit a 14-year low.

Government and corporate bonds also weakened, while gold and the dollar rallied.

The gloomy tone across markets served to heighten the challenge Mr Obama and his economic team face as they flesh out a planned fiscal stimulus and deal with a stricken banking system.

“The next 30 to 60 days will be very important for the market,” said Anthony Conroy, head of trading at BNYConvergEx. “This is really the start of the year for investors as we will soon know details of the fiscal stimulus and how it will proceed.”

The S&P 500 closed 5.3 per cent lower on Tuesday, surpassing the 2 per cent decline of 1981 when Ronald Reagan was inaugurated amid economic distress.

Concerns about the global banking system and the increasing role of governments in supporting the financial system are weighing heavily on investors.

The S&P financials index tumbled nearly 17 per cent to a level last seen in April 1995 as shares in Wells Fargo, JPMorgan , Bank of America and Citigroup fell sharply. Regional and custodial banks were also pressured, dragging the broad market lower.

Already this year, shares in BofA have fallen by more than half and the US government is now the largest shareholder after extending support last week.

The real challenge for the administration rests in stabilising a banking system that continues to struggle with mounting losses from credit and mortgage assets amid a deteriorating economy and housing market.

Alan Ruskin, strategist at RBS Greenwich Capital, said: “Wherever you look, the financial news is dreadful and there is no question that hard decisions need to be made about financial institutions.”

With banks under pressure from writedowns and losses, their capacity for new lending remains impaired and that continues to squeeze debt-laden companies and consumers. Investors fear any large stimulus plan will fail to revive the economy unless banks and the credit system function.

The administration is exploring setting up a “bad bank” to take toxic assets from US banks and ringfence the financial system from losses. Other options include backstopping banks and their impaired assets, which has been used in shoring up Citigroup and BofA.

A bad bank, known as an “aggregator bank”, could be financed initially with the $350bn not used from the troubled asset relief programme created in the wake of the Lehman Brothers bankruptcy. However, many analysts expect a successful bad bank programme would probably require further funding before the financial system is stabilised.

Investors will focus on what Lawrence Summers, the new director of the National Economic Council, and Tim Geithner, nominee for the Treasury secretary, will say about the banking system.

The latest selling pressure on banks weakened the appetite for government bonds.

Investors expect further government help for the financial system will translate into greater sales of treasuries as Washington ramps up its borrowing. Weakness in US bonds was also driven by a sharp sell-off in Europe and the UK as investors fear the cost of bailing out banks.

Bond traders are braced for a dramatic rise in debt sales this year and worry that the Obama administration will surprise markets with a larger stimulus package than announced.

Gold rose more than 3 per cent to $863 an ounce, while the dollar rallied against the euro and sterling as UK banking ills and the credit downgrade of Spain by Standard & Poor’s reverberated across the currency markets.