As banks' recognized losses in the sub-prime scandal top $100 billion, we have been experiencing the first bouts of major bear-market panic.
First a nasty plunge in world stock markets, encompassing even ones that have been relatively resilient, such as India. Then big cuts in the US central bank's charges for lending money to the banking system. Followed by a bounceback in share prices, with some optimists even arguing that the worst of the correction in an ongoing bull market is over!
All this is normal market behaviour. But my own view is that we are in the early part of a major bear market, with a lot more downside to come in the values of most investment assets over the next two or three years.
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I am not alone in this somewhat pessimistic view. Thomas Mayer, co-head of global economics at Deutsche Bank, argues that the international financial crisis "is unlikely to blow over fast" because it requires painful adjustments, not only by banks, but also by private households.
In other words, they've got to write off their big losses, reduce debt, boost their saving, and adjust their behaviour to a world where cheap credit is no longer on offer to finance profligate lifestyles and aggressive corporate takeovers, on the back of inflating property values and super-profits from globalization.
"Collateral damage to an otherwise fairly healthy corporate sector looks likely," Mayer warns.
The reasons why the emerging problem in the world economy is likely to be a big one, and the probability that it won't blow over fast, are to be found in:
- The number of asset classes involved -- not just tech and dot-con stocks, as in the bursting of the 2000 bubble, but most equities, bonds, real estate and alternative investments.
- The impact of tightening credit on businesses, especially small and midsized ones, and on employment. Financial Times commentator John Authers speaks of "the growing and disquieting evidence that the supply of credit from US and European banks is contracting."
- The shortage of weapons that governments can use to combat the crisis. Interest rates are already low or even negative in real terms, inflation is being driven up by supply/demand shortages in energy and other resources, and state spending increases are constrained by high public debt levels as a consequence of past spendthrift policies.
How did we get to where we are? Bill Gross, the well-known American bond fund manager, explains it well:
"Until recently US and therefore global demand has been driven by the ability to lower interest rates and extend credit to an increasing majority of Americans.
"Mortgages, auto finance and credit cards were offered on increasingly liberal terms and continually lower yield and risk spreads, because of Wall Street ingenuity and importantly the nave endorsement of their black magic by rating services willing to sell AAAs [highest investment ratings] for a fee.
"If you're offered a new home with nothing down and nothing to lose, you'd take it, and many Americans did. If you're offered a new car with 0 per cent financing for five years, you'd buy it, and many Americans still do.
"Demand was bolstered and supported by innovative, securitized finance, which in turn was nurtured by lax regulation. And a belief that things could not go wrong and if they did, that policymakers would make things right.
"The repair, if needed, was labelled the Keynesian compact,' and it made for a deal with the American public: it would be OK to have free markets, because policymakers know enough to prevent another Great Depression.
Financial engineering gone mad
"Demand could always be stimulated with a combination of easy money, budget deficits. Prosperity, in effect, was guaranteed. Well, probably guaranteed. But the historic growth rate of that prosperity may now be threatened.
"Because demand in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck, there is a legitimate question as to whether its black-hole-imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages.
"The $150 billion deficit plan advanced by Bush and the Congress, for instance, amounts to just 1 per cent of GDP and will be of marginal benefit to long-term prosperity
"This package will help the Chinese economy more than ours. Americans will use the rebates to buy Chinese imports and the $150 billion will then wind its way inevitably back to Asian coffers
"Government writing checks for American consumers which then flow to foreign central banks is not the permanent solution; it only makes sense in the short term as a life preserver.
"To provide a stable recovery path, government spending needs to fill the gap, not consumption. Public works programs, badly-needed infrastructure repairs, as well as spending on research and development projects, should form the heart of our path to recovery."
Banks' crisis much worse to come
It's increasingly being realized, as I argued in my initial analysis of the bursting of the sub-prime bubble in August, that its consequence will be a broad-based credit squeeze impacting severely on global economic growth as banks shift to highly conservative lending policies for years to come.
The banks will be under attack from regulators, politicians and their shareholders for pursuing such irresponsible policies in the past. They will have difficulty doing business with other financial institutions burned by their bad, even dishonest, advice in the past, and perhaps continuing to be worried about whether they still have bad debts hidden by optimistic accounting assumptions or in off-balance-sheet vehicles.
Their profits will collapse, adding to the other factors forcing them into low-margin, conservative lending policies. Fat profits from hedge and private equity funding will largely be a thing of the past.
Unfortunately the credit squeeze won't only be due to paranoid bankers. Liberal lending policies depend on the perceived soundness of borrowers and their asset bases.
Traditionally the soundest security of all against which to lend money has been property. But the collapse of home values in the US, and the probable weakness in real estate prices in many other countries where the days of inflation fuelled by cheap, easy credit are now clearly over, is going to rob this asset base of much of its attraction as collateral.
Even equities, the second great asset base, look dodgy:
- Valuations have generally been based on the highest profits relative to economic growth for decades the probability is that they will start regressing to mean;
- Two important sectors are under direct threat financial services and real estate. Financial services accounted for an amazing 41 per cent of the profits of all listed companies in the US last year;
- Multinationals that have blossomed by seizing the rewards of globalization face a period of intensifying competition in international trade as the world economy slows down, and one of increasing protectionism.
Faced with this darkening scenario, we can be sure that central banks and governments will act vigorously to fight back with the two weapons at their disposal cutting short-term interest rates and boosting state spending.
These measures will undoubtedly ease the pain of the coming recession. But they are palliatives, not solutions.
Japan, the world's second biggest economy, tried both. They were successful in preventing another 30s-style slump, and indeed delivered mediocre growth rates averaging around 1 per cent for more than a decade. But they were unable to restore strong growth.
What's more, Japan's circumstances were unique and even favourable in some respects. For example, it has always maintained a relatively high savings ratio, avoiding the US's credit-fuelled consumer profligacy and consequent large foreign-trade deficit.
Cutting interest rates now mainly benefits those who ought to suffer the consequences of their irresponsible behaviour the banks who packaged and sold the toxic waste as "safe" investments; highly-geared speculators, hedge and equity funds; and consumers who took on excessive debt to finance property speculation or profligate lifestyles.
Cheap money isn't the answer
The forces that drive economic growth, such as export demand, capital investment by businesses, major breakthroughs in productivity, even consumer spending, are not particularly sensitive to changes in short-term interest rates.
In any case, with central bank policy rates down to 3 per cent already in the US, at not much higher levels elsewhere, and at low or negative levels in inflation-adjusted terms, the "stock" of rate-cutting "firepower" available is not great.
The other counter-recession weapon massive spending by the state takes time to mobilize and implement. Although it can have some side-benefits, such as modernization of infrastructure, it inevitably produces a great amount of waste and bloated bureaucracies to administer it. The money borrowed to finance it builds an enormous burden for our children and grandchildren to carry.
Unfortunately we are going to have to live through a relatively long period of adjustment. Banks are going to have to swallow their excreta and regain investors' trust. Consumers are going to have to adjust their lifestyles and work down their personal debt. Corporations are going to have to adjust to a much tougher business climate.
But there are grounds to be optimistic if you look beyond the immediate future:
- Emerging market and developing countries, less exposed to current financial turmoil, seem certain to spearhead recovery in the world economy.
Deutsche Bank reckons that last year those countries accounted for almost 70 per cent of global economic growth, with China providing more than twice as much growth as the US and India as much as the Eurozone.
That provides some measure of their potential for driving future growth, especially as their internal demand takes over some of the momentum they've received from exports.
- The inherent dynamism of American capitalism and its political system suggests that the US will act aggressively to deal with its problems compared to, say, Europe or Japan.
It's still the world's biggest economy by far, and will continue to be for many more years. By the beginning of the new decade I expect America, with its formidable resources of technology, management skills and scale of operations, to resume a major positive contribution to world economic growth.
- Although inflation is currently a problem restricting the freedom of action of central banks and governments, it's likely to be less of one as economic growth slackens and high prices of energy and other resources act to depress demand.
That will provide a base for a new level of world economic growth.
So buckle up for a rough ride in global markets while planning where to invest after a safe landing.
By Martin Spring in On Target, a private newsletter on global strategy
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