The Icelandic job

Yikes! Where did all the money go? Recent events have left many Icelandic investors feeling like victims of a robbery. While most of the world’s markets have been hard hit in recent months, few have been crushed in the way the Icelandic market has.

The rise…

For those less familiar with the Icelandic economy and stock market, I will start with a little background information. The country has been on a tear since 2002. That is not due to any amazing increase in exports, but rather by an explosion in the availability and use of credit and the ability to participate in global financial markets. An ability Icelanders were long deprived of and have now embraced enthusiastically. This led to a surge in equity and real estate prices.

The vast majority of the market´s capitalization consists of banks and investment companies (which in turn tend to be heavily invested in the banks). Company valuations never seemed unreasonable as measured by P/E ratios, although the earnings were driven by massive capital gains and an enormous growth in all kinds of capital markets activity. In recent years, Icelandic investors (including the banks) have been on a buying spree, most notably in Scandinavia and the UK. For about five years, this worked like a charm. Whether this was due to the acumen of Icelandic investors or a global bull market I will leave unsaid, but the former explanation was more popular in Iceland.

…and the fall

It is hardly surprising that a small market driven mostly by finance has not done well in the turbulence of recent months. Since its peak on July 18th, the Icelandic market has lost half of its value in the local currency, the Icelandic Krona (ISK). To make matters worse, in the same time period the ISK has fallen by 30% against a trade-weighted basket of currencies.

There are certain elements that make the Icelandic market susceptible to positive feedback loops such as the current downward spiral. Most notable is the heavy use of leverage, which is sometimes employed on multiple levels. A typical example of this is a private investor taking a loan to buy shares in a leveraged investment company, which in turn buys shares in banks with aggressive growth strategies.

Another factor is extremely high interest rates (the Central Bank’s benchmark rate is 13.75%), which leads many investors to finance their domestic investments in foreign currencies. As the currency falls, the investors are forced to sell assets to repay loans.

What to do?

I have no idea where the stock market will go from here. The Icelandic banks have remained profitable so far and have not had major asset impairments. The banks claim that the credit default spread market, which suggests that a default of the Icelandic banks is getting more likely by the day, bears no relation to reality as the banks are well funded and do not have assets of the lowest quality, such as subprime mortgages. However, banks do live and die by their reputations and I would not be confident ruling out that some self-fulfilling prophecy could harm the Icelandic banks, and thereby the entire stock market, further.

What I am beginning to take a closer look at, however, is the ISK carry trade. The ISK is at a record low and interest rates remain very high. With the recent decline of the ISK the Central Bank of Iceland has stated that interest rate cuts are not on the horizon. Bond yields have been falling, but are still high in international comparison, yielding over 4% inflation-indexed.

As this opportunity is presenting itself, many of the investors most familiar with the Icelandic market are not in a position to take advantage of it, both due to their deteriorating financial standing and to loans in foreign currencies being hard to come by in Iceland these days. For those able to execute this trade, however, I think it is worth looking at.