Writing amidst the continuing turmoil in financial markets one question keeps popping into our minds: Will the financial market crisis morph into an economic crisis?
Although central bankers appear sanguine regarding current conditions we are increasingly coming to the view that central banks simply adding liquidity to the financial markets through the aggressive injection of funds is nothing like good enough, investing institutions being likely to hoard the cash to provide protection against possibly worse to come.
Central banks, led by the US Federal Reserve, must countenance aggressive monetary action if confidence is to be restored and a very deep economic crisis avoided. We have already drawn attention to the fact that precedent for aggressive action already exists, so the Fed would by no means be entering uncharted waters if it acted outwith its regular monthly meetings. Our view is that the Fed must cut rates by 1% point and that it must be done soon. Without it, the crisis shows clear signs of infecting the commercial paper market, the $1000bn place from which companies derive the funding for investment and for hiring workers.
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At the time of writing we are concerned that Fed officials show few signs of desire for base rate action. Taking their cue from US Treasury Secretary Hank Paulson's observation that market turmoil actually represents a welcome repricing of risk, certain regional Fed governors including, in particular, Mr William Poole (president of the Federal Reserve Bank of St. Louis) are showing few signs of recognising that the financial market crisis is turning into an economic crisis and that there was, in his view, no need to be "bounced" into an intra-FOMC meeting rate cut.
Given this apparent intransigence it might be appropriate to consider the circumstances in which the Fed absolutely would cut the Fed Funds rate.
Firstly, and drawing on the experience of 1998, the collapse of a major financial business. Back then it was Long Term Capital Management, a previously much vaunted hedge fund company populated by large numbers of highly qualified professionals whose ability was only exceeded by their egos! To prevent what it saw as the risk of a systemic crisis in the financial markets in the wake of LTCM having "bet the wrong way", the Fed stepped in. It may yet be forced to do so again.
Secondly, the possibility that economic fundamentals might be adversely impacted by volatile financial markets, raising the possibility of a recession. An embattled President hardly needs the US economy to sink into recession a little over a year before his successor faces a rejuvenated Democratic Party at the polls.
Thirdly (and very pertinently given the apparent spread of the banking crisis into the commercial paper market), the possibility that the same dislocation might result in higher financing costs for commercial businesses, impacting on funds available for investment.
Why this could morph into an economic crisis
As everybody now knows, the seeds of this financial market crisis began with a seizure in the so-called sub-prime mortgage market in the United States. In fact we might be tempted to go further and look at the vast structural imbalances which characterise the global economy and which led directly to increased demand amongst investing institutions for debt-related instruments. However, for now the sub-prime market represents as good a starting point as any.
A problem emerged when the income required to service a mountain of personal debt proved insufficient in the face of higher borrowing costs, tighter credit conditions and gradually falling asset values. Bear in mind that even if the US Fed does cut base rates before its next scheduled meeting, those US households have only just started the process of re-fixing and that it is likely to be Q3 2008 before the process is over. Note too that in excess of two thirds of these refixes are in the sub-prime segment! The point is that, even if the Fed does move aggressively to shore up confidence it may be insufficient to make much difference to households who were lured into overextending themselves more by attractive offers than once low base rates (source: the Fed's own staff report!).
What makes this financial market crisis different to, say, 1998, is the extent to which that was a relatively localised event specific to the derivative and currency markets. This time, the contagion has spread quickly across all global financial markets. The reason, the collapse in sub-prime has mutated into a generalised (and warranted) fear regarding the collateralised debt market the foundation for confidence and trading across a wide variety of debt-related products. As the market dries up so demand for cash increases, resulting in unsustainable stress on hedge funds which do not have sufficient cash to meet possible redemptions causing the fire-sale of more liquid assets such as equities and other financial instruments and a general flight to traditionally defensive investments such as short-dated US Treasuries and the dollar.
So Far, So Bad!
Where things really start to get nasty is when the largely banking-related meltdown (bad enough!) becomes a problem for the real economy. Where Main St. meets Wall St. is in the market for commercial paper, a market said to be worth c$2.0tr in the US alone. Commercial enterprises use the commercial paper market to derive the financing for their investing intentions such as spending on plant, equipment and workers. According to the Financial Times' Lex column on Thursday 16th August, around half of this market is potentially at risk as it too is supported by asset-backed securities including credit card debt, car loans and, you guessed it, mortgages! As the authorities flail about attempting to find a suitable victim on whom to pin the blame for the current crisis the credit rating agencies have come into the firing line (rightly or wrongly) and as a consequence a renewed sense of embattled pessimism has manifest itself in the latter's threat to start downgrading the issuers of commercial paper!
The Fed may wish to let the markets stew in their own juice for a bit, but the almost inescapable fact is that if banks can no longer securitise loans because investor demand just isn't there and those same banks may be fearfully eyeing the prospect of increasing loan-loss provisioning, the chances are that the flow of credit from the financial sector to the commercial sector could easily stall. We have noted, before, that total US debt has now risen to 360% of GDP, far, far ahead of the previous peak recorded at the height of the depression in 1933 and at least three times the levels expected at this point in a normal economic cycle.
Now, like startled rabbits staring into the glare of the oncoming juggernaut, we face the strong possibility that the life blood of the corporate sector may be about to be switched off. This bad news, coupled with the near inevitability that consumer spending will be depressed by the psychological and real impact of falling house prices and falling stock markets must mean that the US economy is in for a growth "shocker" when Q3 2007 Gross Domestic Product data gets released in late October / November this year.
The problem with that last sentence is that it's likely to be at least another two months before we start to see what the fall-out from the current turmoil actually is. Note, too, the point made above regarding the fact that the sub-prime crisis is going to continue for another year irrespective of whether the Fed cuts base rates now or not. This means that the current environment of uncertainty (who knows for sure what the size of sub-prime related losses amongst the banks is? Who knows for sure exactly who's holding the toxic waste? Who knows how massive the hit to the banks' balance sheets might be as the bridging finance to hedge funds start to collapse?) is likely to continue and that matters because what we get asked time and again by investors is when should we start to commit the cash that we so diligently hoarded by selling in May and going away. Steep equity market falls are historically regarded as the precursor to an equally steep rebound. The problem this time is that as the debt mountain of the past keels over, it could take a very long time for confidence to be restored.
A Consumer-Led Recession?
Perhaps the biggest uncertainty pertains to the consumer. A US savings ratio at 0 and debt service costs at record highs at the same time as unemployment is rising (manufacturing jobs are being lost, jobs in restaurants and theme parks are being created!), house prices are falling, stock markets are falling and lending conditions are being revised are not positive conditions for a further improvement in either confidence or spending. The difference between conditions now and conditions that existed at the time of the last consumer-led downturn is that in 1990 one bad quarter of consumer spending resulted in a mild growth slow-down. What we are looking at now is a real downturn in consumer spending and the last time that happened was the deep recession of 1980!
Investors looking for bargain hunting opportunities should bear in mind that prospects for corporate profit growth may be less rosy in the future than they have been thus far. We note the extent to which corporate profitability stands at record levels in the context of the total value of the world economy. Whilst bargain hunters might look for opportunities to commit cash to equities, we would recommend either a firm defensive bias or stick to those companies whose growth prospects are truly better than that of the world economy. Given the uncertainty, the latter strategy carries considerable risk.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
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