Wednesday, 10 December 2008

Happy days waiting around the corner?

Over the past week or so, it appears that the level of confidence in the financial markets has improved several notches. Trying to summarise why, one arrives at a situation more or less as follows:

  • Led by the Federal Reserve, the world's central banks are doing what is necessary in order to improve the situation in the financial sector, and even to bypass it if necessary. Fed has even begun to monetise the public sector deficit – known as printing money – and bypass the financial sector in creating credit
  • Across the world, with China as the leaders, political leaders are putting in place fiscal stimulus in order to get the economies going
  • Long term interest rates are plunging
  • Commodities and in particular crude oil have fallen so much in price that it will stimulate the economies
  • Stock prices are almost at a giveaway level
  • By third quarter of 2009 we will have seen the worst of the downturn and we will be on our way back to better times.

I would like to be able to join in that happy chorus. I am also slightly more positive about the future economic developments than I was six weeks ago, mainly because it appears that politicians across the world are ready to scrap the traditional way of thinking. By this I mean the conventional wisdom of economic policy as it has been understood more or less since the Reagan-Thatcher era.

However, I have quite some difficulty in joining the optimists. Let us try and take each of the arguments above and look at it.

Central banks are certainly doing a lot. Two weeks ago Federal Reserve began monetising the debt and introducing several instruments allowing for a closer control of the conditions in the money market. It was announced that Fed would be interventionist regarding the yield curve and that financial assets of a highly troubled nature could serve as collateral for facilities with the Fed. The effect has been a predictable fall in US yields along the curve, and direct intervention in the mortgage market has led to a narrowing spread for MBS over government bond yields. The effects of this have spread to Europe, where the central banks have cut interest rates to unprecedented levels. European central banks have not yet, however, begun a process of quantitative easing. I consider this to be all positive, as the Fed has reacted quickly and fully in line with what is necessary. Fears of this leading to inflation are overdone, as the Fed can easily mop up the excess liquidity once the situation is better.

In Europe, the banks are in general in a much better state (with the UK as the possible exception). The current "credit freeze" may be more severe than what is completely normal in a period of economic downturn, but there are good reasons to believe that the governments will let their voices be heard clearly in their capacity of part-owners of many banks, pushing for less strict credit conditions. If that should not work, there are several more instruments left, most notably in the repo-area, where the central banks can accept progressively worse assets as collateral for liquidity.

Governments are working overtime in order to stimulate the economies. Or are they, really? So far US lawmakers have done nothing, understandable given the limbo period before the swearing in of the Obama administration. He has, on the other hand promised rapid action after 20 January. So far he has been talking of packages to the tune of 2.5 percent of the GDP. Not half enough to stave off a deep recession, as it lurks behind the horizon. Given the need of US households to consolidate their balance sheets, the recession will be deep or it will be a medium recession followed by a long period of sluggish recovery.

China presented an impressive package, supposed to be worth more than $500bn of government stimulus. Upon closer inspection, a significant part of this happened to be infrastructure spending which was already planned in advance. So the overall short term impact will be much smaller than announced.

Across Europe, the governments are presenting each a package of their own. According to the estimations of the EU commission, the overall effect will be some 1.5 per cent of EU GDP. Some of the initiatives were in place before the crisis hit and some are brought forward. Net new initiatives are likely to be somewhat less than 1 per cent of GDP. Some will work very well (announced infrastructure projects in Denmark, France and Germany) but will be slow in the coming. Some will not work as desired (temporary tax reductions or VAT cuts). Summarising it all, the effective stimulus in Europe will be significantly smaller and slower than most people are meant to believe.

Long term interest rates have been plunging. Bond markets have been reacting absolutely rationally to the change in the US monetary policy and the world is profiting from it. In particular it will be positive for troubled home owners, who will be helped to refinance with long term loans at low rates. And companies in need of long term finance should find it easier to issue bonds. Whether anybody will buy them is still anybody's guess. Some – including myself – are worried about the long-term effect on inflation and hence, on the long bond yields. It is not a relevant issue right now, and will be addressed when the governments or central banks find it appropriate to tighten monetary policy.

Commodities and oil have fallen considerably, offering an impetus to the markets. Quite correct, but the prices have fallen from speculative levels and are likely to have undershot meaningfully on the way down. After all, commodities and oil have to be priced at least at levels where they can finance the search for new sources as the existing mines/oil fields dry up. That may not be the case for several items right now and they will begin to move back. And nobody could take the 84% fall in Baltic Dry rates seriously. Anyway, the world did not enter a recession because of high commodities and energy prices. So yes, the current low level of commodities prices are a plus, but unlikely in itself to pull us out of the recession.

Stocks are cheap. Oh, really? Yes, if you compare to the peak of valuation in the summer of 2007. And of course if you assume that companies will return to the same level of profitability seen in the first half of 2007. And provided that valuations improve.

What will happen if they do not get back to the same profitability levels? My guess is that they will not anytime soon revert to those happy days. The banking sector will be hobbled for decades to come, as regulators de facto will tighten reserve requirements visibly and for an extended period of time, introduce limitations to the bank's activities.

It will reverberate into other sectors because credit will be less readily available and in particular, financing M&A activities will be hurt. Venture funds and private equity funds, who have been important players in the "grey" credit creation, are likely to be regulated in a rather more strict way.

In order to return to profitability, companies in all sectors will depend critically on a return to sustainable economic growth. Eventually, economic growth will return. But for a span of years, it is likely to be slower than seen in the past 10 or 15 years. There are two reasons for that. A good deal of the growth was credit financed, a driver which will be off the table for an extended period of time. Secondly, we are not only looking at a situation where new credits will be limited, we are looking at one where existing credits will have to be reduced. The size of this debt overhang in the US is significant enough that it will take years to work it down. In that period US consumption will grow slower than before and be a drag on the world economy.

With growth below par, and finance for M&A drying up, the case for a rapid return to profitability is weak. Unless the Asian consumers suddenly turn themselves from being excess savers into excess consumers.

Even if stock markets return to profitability, there is no guarantee that valuations will begin to pick up either – exactly for the reasons mentioned above.

By Q3 2009 we have seen the worst. Stock markets still celebrate themselves for being able to predict turns in the economy 6-9 months ahead. Yet they did not see the current recession coming, so the predictive ability of the stock market appears rather jaded.

But still, things will turn in late 2009? I hope so, but am not too optimistic. The fiscal stimulus packages appear too small and too late in the coming. There is a new wave of resets on 'Alt-A' loans coming in the first months of 2009. We have still not seen the full impact of the Credit Default Swaps. The economic downturn has become sharper in recent months, but we have not yet seen the traditional surge in corporate defaults. Once that happens, we will find out how bad the situation is in the CDS market. I am afraid that it may not be a pretty sight.

So all in all, while too much pessimism is not good for the markets, I still have some difficulties in letting myself be swept away by any wave of optimism..

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