Tuesday 9 August 2011

It's the debt, stupid


Stock markets are plunging on an unappealing cocktail of worries about economic growth, the handling of sovereign debt problems, the apparent inability of politicians to bail out the markets when the markets really want it, and a handful of other assorted ailments. 

Given that analysts now realise that growth in 2H of 2011 is going to be slower, they are working overtime to adjust earnings estimates. Those estimates will invariably be lower than the pie-in-the-sky estimates of just two weeks ago, and the assumed valuations of the stock markets may take a serious blow.

How come that the adjustment to slower growth has come so quickly? At my company, Origo, we have warned about the “soft patch” ahead since late March, when early indicators showed that the US economy was in for a slowdown. European indicators have been unequivocal since April. That was also the month when commodities took notice.

On the other hand, bond markets have been right on the ball this time. Bond yields of high quality sovereign debt have fallen in the past months, giving another clear indication that something was afoot.

However, indicators of (stock) market euphoria have shown the increasing divergence between the optimism in the stock markets and the increasingly gloomy economic background. The speed of adjustment indicates what has been obvious for some time: stock markets have been living in their own little bubble for a while, and that bubble has now burst.

Summing up all these indicators, we arrive at a picture of the best announced stock market correction for a decade. The stock markets have yet again failed to predict important economic trends. Now they are rapidly adjusting and “Double-dip Recession” is now a favourite buzzword.

Which brings me to my point. For those who believe that the decline in the stock market reliably predicts a new recession, remember the famous dictum of the late economist Paul Samuelson: “The stock market has predicted nine of the last five recessions.”

I do not think we are heading into a global recession, i.e. a new period of negative growth. But I do believe that we are heading into a period of growth below trend. Remember that this economic crisis is not your standard run-of-the-mill recession. We are cleaning up after a major debt-fuelled party. It means that households, particularly in the US and the UK have to redress their balance sheets. It takes time to bring down debt, and in that period consumption has to be lower. Obviously it also hurts the banks that have financed the party.

It would not have taken more than a few years if the public sectors were in a position to let their balance sheets deteriorate for a period. That has historically been the role of the public sector in smoothing out economic cycles. But many countries were not in that position when the downturn started in 2008. Public sector finances in USA, UK, and some smaller European countries were hit full force.

At the same time the countries that could have afforded to expand their balance sheets were gripped by fiscal conservatism. The results have not been encouraging. We now have a situation where both private and public sectors are working to consolidate their balance sheets. That leaves the monetary policy to do the job of getting the economy moving.

It can’t. Monetary policy can only create the conditions for growth, and central banks have certainly done so. But when the consumers and business leaders are more focused on reducing debt than increasing loans, adaptive monetary policy won’t work. In such a liquidity trap, the money created by central banks in all likelihood fuels speculation in financial assets instead.

Oh, and in the longer term, it may be inflationary. Some voices are already afraid of an impending hyperinflation. In the big picture, however, such fears are pushed aside as asset reflation is supposed to make consumers feel better and hence more prone to consumption.

Central banks can reliably be counted upon to support the stock market this time around, too. It does not change the fact that we probably are heading into that period of below-par growth that may last for quite a while. It may not be a recession, but growth will be slow enough that it feels like one. I don’t know who came up with the expression “the new normal”.  But I do think that it is what we are looking at now. 

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